Owner-Oriented Investment Research and Commentary - Have a private comment or question? Email us at commonstocksense@gmail.com

Thursday, May 21, 2009

Mediasite Use Beyond the Classroom; Expect More from the "Engine"

We won't always plug our companies on this blog, but wanted to relay several notable events for Sonic Foundry's (SOFO, $0.71) Mediasite solution beyond the classroom:
  • Anyone watching the news last weekend (May 16-17th) couldn't help but hear about First Lady Michelle Obama's commencement speech at University of California Merced. The event was carried on television and streamed live via Webcast to more than 3,000 computers. The engine behind the Webcast was none other than Mediasite (link here).
  • We learned of another non-traditional event through Sonic Foundry's World of Webcast blog (link here): OfficeMax launched a new product line using the blog of a star from The Learning Channel's (TLC) show "Clean Sweep" (Peter Walsh). Rather than the usual video plus slides Mediasite format, they used an embedded video Mediasite player which looks quite slick (link here).
  • Public swine flu updates from a number of universities/organizations that use Mediasite - links available at World of Webcast.
In addition to these recent events, one of Sonic Foundry's largest event services customers, Autodesk (ADSK, $18.84) is leveraging a variety of Mediasite formats to position/share/sell content captured for Autodesk University (link here). Autodesk has three years of content captured with Mediasite (December 2008 Sonic press release with details here).

Many companies host user group and/or customer conferences each year. Most still use audio only Webcast formats (slightly lower cost), although some use Windows Media Player video plus separate, non-integrated, non-synchronized PDF/PPT files (example: Qualcomm's BREW conference - 2008 link here , QCOM $41.43). While we're biased, we've not only evaluated the competitive landscape, but also watched hundreds of Webcasts in recent years. Nothing we've seen holds a candle to Mediasite (*please let us know if you see or think otherwise). We believe any organization or business wishing to connect with interested parties would be remiss to not consider using Mediasite to capture sessions and make content available live and on-demand (free or fee-based).

We expect to see more and more embedded Mediasite players on the Web going forward as the Mediasite franchise grows. While the technology landscape can change quickly -- which keeps many investors out of tech altogether -- we view Mediasite as a utility that becomes part of the way organizations operate and entrenched in their hardware/software infrastructure.

A less-than-perfect but still relevant analogy might be the following: Mediasite is to Webcasting as a jet engine is to flying. Many companies no doubt tried to make jet engines through the decades, but only a handful emerged as market leaders (e.g. General Electric, Pratt & Whitney, Rolls Royce). For Webcasting, Mediasite is increasingly the go-to platform with quality and reliability both immensely important since many customers (e.g. schools) use the system daily to capture and archive hundreds of hours of content.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, May 20, 2009

Everyone's An Economist

Arguably, public sentiment shifted from one of great fear to one of cautious optimism and acceptance as in, "okay, things are bad, we know that, but let's get on with life and look forward." However, in early 2009, we couldn't help but notice that everyone was or wanted to be an economist! The negative sentiment was recently highlighted in commentary from Southeastern Asset Management ("Southeastern"), a manager we respect and track from time to time. Southeastern is the investment adviser to the Longleaf Partners Funds with approximately $22 billion under management.

On 4/17/09, Southeastern released "First Quarter 2009 Commentary" and, on 5/07/09, the manager's full quarterly report was published (both can be found here). Just this week, the firm hosted its annual shareholder meeting (audio/slide presentation available at same link). We have no tie to Southeastern and are not invested in the Longleaf funds, but highly recommend a read of the commentary.

In the shareholder letter, Southeastern points out that never before in their long careers had popular attention given to macroeconomic conditions so completely displaced focus on fundamental analysis -- we summarize further: everyone is or wants to be an economist! Thanks to the rapid flow of information worldwide (Internet!), fear ran rampant last fall and into 2009 as the daily news of downward market trajectory beget more uncertainty amidst all economic participants, consumers and corporations alike. The state of the economy became top of mind literally around the world.

As a result of infatuation with macro trends and overwhelming fear, the Southeastern letter goes on to say that now is/was the best time for long-term investors to roll up their sleeves and buy high quality businesses trading at significant discounts to fair/replacement value. Although we don't have the decades long perspective of Southeastern, we concur with the key themes relayed by the firm.

Some readers may NOT be surprised that a "long only" portfolio manager is so bullish, but Southeastern supported the buy-on-fear, stocks-are-cheap view with quantitative, historical analysis on page nine of the firm's 4Q08 shareholder report (link here). The analysis compares the S&P500 earnings yield to the 10-year U.S. Treasury Yield at various points in time and was updated for this week's shareholder meeting. Their work shows that the positive S&P spread narrowed to 3.9% presently from 7.0% at March 9th market low. The yield advantage remains compelling, especially since earnings have potential to recover/grow meaningfully over time while bond coupons are fixed and, aside from TIPS, erode with inflation (whenever it arrives).

Although short-term market moves often mean very little, the letter appears prescient as fear subsided somewhat since March/April and many companies are now trading at multiples of recent lows. Examples: Central European Distribution Corp. (CEDC, $24.50), eBay, (EBAY, $18.25), Expedia (EXPE, $15.74), FedEx (FDX, $56.60), Liberty Media Interactive (LINTA, $6.18), Marriott (MAR, $23.06), Starbucks (SBUX, $13.92), and Whole Foods Market (WFMI, $21.03), Wyndham Worldwide (WYN, $11.78), and the list goes on.... Southeastern owns some of these companies.

Of course, we're cognizant of overall economic conditions: the economy is still contracting, job losses continue, government deficits are rising, and consumer spending may remain subdued in both the near/medium-term. For some sobering but insightful reads, we recommend the monthly commentary of Annaly Capital Management (NLY, $14.68, a mortgage REIT - link here). In addition, the Federal Reserve Bank of San Francisco published on May 15th "U.S. Household Deleveraging and Future Consumption Growth." The research points out just how indebted U.S. consumers are versus historical levels with telling graphs (link here).

Still, companies with durable franchises can be valued as the net present value of future free cash flows to equity holders into perpetuity. This approach illustrates that a rough patch of even several years only modestly reduces free cash flow based intrinsic values per share and gives confidence to purchase highly discounted equities despite enormous near-term uncertainty and negative growth (side bar: generally we prefer current year growth since it, along with a low multiple, can keep investors out of trouble) .

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long CEDC, EBAY.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Thursday, May 14, 2009

Youbet.com Alive, Kicking and Even Growing

Since our 3/23/09 Seeking Alpha post (link here), shares of Youbet.com (UBET, $2.47) are up 56%, which compares favorably to the S&P 500 up 15% and the Russell 2000 up 18% over the same period. Certain "niche franchise Internet companies" such as Blue Nile (NILE, $42.02) and The Knot (KNOT, $8.13) also rallied, up 63% and 17%, respectively, while others such as Stamps.com (STMP, $8.42) were flat to slightly down. We compare Youbet to what we call niche franchise Internet companies since they all have asset light business models with similar operating margin profiles and capital requirements (*Youbet's core online segment, excluding tote segment).

Back to Life

Shares of small-cap Youbet.com recovered from fire sale valuations of 2008 (20-30% free cash flow yields) created by company- and industry-specific issues that left the stock for dead. The market is now realizing that overhangs are removed and that Youbet is a viable, well-positioned, cash generating business. As a result, the extreme valuation discount is narrowing.

Positive Catalysts Over Past Two Months
  • 3/16/09 Introduction of "Conditional Wagering"
  • 3/26/09 Introduction of new international racing content
  • 4/01/09 Extension of share repurchase program
  • 4/22/09 Agreement to carry Calder Race Course (a Churchill Downs track)
  • 4/25/09 Agreement to carry Churchill Downs (namesake track)
  • 4/27/09 Agreement to carry first leg of Triple Crown, the Kentucky Derby - first time since 2006
  • 4/30/09 Seasoned management hires for business development/strategy
  • 5/01/09 Agreement to carry Arlington Park - first time since 2006
  • 5/13/09 Agreement to carry Preakness Stakes - first time since 2007 and confirmation that Youbet will carry entire Triple Crown this year
  • Press releases are available here with more information
In addition to the above developments, Youbet.com is supporting recently introduced Internet gambling legislation that would legalize online gambling. While placing wagers on horse racing is already legal, Youbet could potentially extend the company's platform into other gaming areas to grow the business. We note that timing on this front is uncertain and any new initiatives would entail execution, competitive, and legal/regulatory risk.

Results On Track - Growing Through Recession


Youbet.com reported results Wednesday after market close which reveal continued progress (link here). On the back of increased racing content, total revenue increased 16% Y/Y to $28.4 million while income from continuing operations was flat Y/Y at $1.2M. Reported GAAP net income per share was $0.03 versus $0.02 in the year ago period and income from continuing operations was unchanged Y/Y at $0.03. Higher content costs in the Youbet Express (online ADW) segment related to new content from Churchill Downs partially offset top-line growth and a $1.2 million operating loss in the United Tote segment eroded overall profitability. The increased content costs were expected and the company continues to explore a potential sale of the tote segment. Certain results from the ADW segment are worth highlighting:
  • Total wagers (handle) increased 30% Y/Y to $124 million with gross revenue of $24 million (+26% Y/Y) and net revenue of $9.1 million (+13% Y/Y).
  • Estimated "same-track, same-state" handle increased 4% Y/Y as the company succeeded in driving more wagers per customer. Youbet cited a "10% increase in average weekly unique wagerers and an 18% increase in average wagers from them over the first quarter of 2008, with the positive trend continuing into the second quarter of 2009.”
  • Gross profit increased 10% Y/Y and operating expenses were up only 8% Y/Y, leading to a 15% Y/Y increase in income from continuing operations to $2.6 million.
  • Income from operations represented a 10.5% margin on gross revenue, down 200 bps Y/Y, but was 27.1% margin on net revenue compared to 28.5% in 1Q08. We see the margin levels and absolute dollar increase as impressive given increased content costs.
  • Importantly, if Youbet operated only the ADW segment, EPS would have been $0.06 for the seasonally weak March quarter, illustrating the earnings power of the business. This is an untaxed figure since Youbet has approximately $60 million in federal and state net operating loss carryforwards that will prevent cash taxes for many years (note: in our first UBET post, we incorrectly stated only $24 million in NOLs).
Overall, the company generated cash flow from operations of $3.3 million and free cash flow of $2.6 million after capital expenditures. Owner free cash flow -- net income plus depreciation and amortization less capital expenditures -- was $2.4 million. Net cash on the balance sheet increased to $6.5 million, up $11.2 million Y/Y from a net debt position of ($4.7) million. Despite the steadily improving balance sheet, Youbet did not act on the company's share buyback authorization. We presume the inaction is related to restrictions surrounding potential strategic alternatives for United Tote.

Stock Still Attractive

To review, our Youbet thesis was as follows: the key overhangs of the past several years are largely removed and Youbet is now well positioned to deliver top- and bottom-line growth this year with consistent free cash flow generation that will continue to build cash on the company’s balance sheet. Moreover, over the past decade, Youbet established an asset light business model with a leading online wagering franchise – brand, customers, platform, marketing partners, and track relationships – that is difficult to replicate.

Following the recent move, UBET is trading at 19 times 2008 earnings (5% earnings yield) and 8.6 times owner cash flow (12% yield). On 2009 estimates, the stock trades at 14 times earnings (7% yield) and 7.4 times owner cash flow (14% yield). We think growth in 2009 and a low cash flow multiple provide both downside and upside support for the stock.

Absolute valuation: on 2008 results, a 10% owner cash flow yield implies a fair value of approximately $3.00, while a 5% yield would imply a value of nearly $6.00.
  • We believe Youbet's core online business has durable competitive advantages and generates stable cash flow, which warrant further multiple expansion. The ADW segment generated income from continuing operations of $8.8 million in 2008. If we grow this income 15% in 2009 (consistent with 1Q09's performance) to $10.1 million and assign a 7% yield, implied segment value is $144 million or $3.40 per share.
  • Valuation of the United Tote segment is less certain given challenging industry conditions (lower wagers, pricing pressure), yet we estimate the segment contibuted approximately $3 million of owner cash flow in 2008. This cash flow, plus the unit's market position and marquee track customers (e.g. Churchill Downs) are worth something. Youbet carries the segment assets at approximately $23.5 milllion and, assigning Youbet's entire $11.2 debt load to the segment, produces an implied net asset value of approximately $12 million, or $0.29 per share. However, a 15% owner cash flow yield (7 multiple) implies segment value of $20 million, or $0.48 per share. A 50/50 segment valuation yields $16 million, or $0.38 per share.
  • Including net cash per share of $0.15, the sum of the parts valuation implies a total value per share of almost $4.00 giving no credit for potential expansion into new gaming markets (since timing and business models are uncertain).
Relative valuation: on 2008 results, UBET continues to trade at a meaningful cash flow and earnings discount to both gaming companies and certain niche franchise Internet companies.
  • Gaming: Youbet trades at approximately one third the owner cash flow multiple of Churchill Downs (8.6 times versus 29.4 times) despite much lower capital requirement (1-2% of sales versus 10%) and higher ROE (29% versus 8%).
  • Niche franchise Internet: On an earnings basis, Youbet trades at a fraction of multiples awarded to Blue Nile and The Knot (19 times versus 56 and 63 times, respectively, on 2008 figures where the first nine months of the year weren't so bad for retail/media). Youbet looks even better on a forward basis since the company is growing while the others are shrinking.
  • We include a comparable company analysis worksheet below.
Conclusion

We continue to believe that operating improvements in 2008 and better fundamentals for 2009 should drive multiple expansion as the market begins to appreciate Youbet’s ability to generate steady, growing free cash flow combined with a high ROE/ROIC. While we need to watch higher content and customer related costs, as well as execution around new ventures, we believe owner-oriented management is committed to profitably growing the franchise and returning increasing cash balances to shareholders over time.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Monday, May 11, 2009

Tale of Two Auction Franchises

Two auctioneers, both established franchises protected by meaningful barriers to entry:
  • One is a household name and operates as a duopoly.
  • The other is only known by customers in its niche market and by focused investors.
  • One serves the luxury market.
  • The other serves the industrial equipment market.
  • One reported March quarter revenue down 58% Y/Y to $54 million and an operating loss of $50 million (excluding $6 million of restructuring costs, compared to an operating loss of $18 million).
  • The other reported revenue up 3% Y/Y to $84 million and operating income of $28 million (+19% Y/Y) for the quarter.
  • One has net debt position of $474 million and generated trailing twelve month cash flow from operations of negative $180 million and negative free cash flow of $202 million.
  • The other has a net cash position of $129 million and generated trailing twelve month cash flow from operations of $128 million and negative free cash flow of $26 million (as a result of planned expansion capital expenditures).
Who are these auctioneers? The first one isn't so difficult to guess -- Sotheby's (BID, $11.98) -- while the second is below-the-radar Ritchie Bros. Auctioneers (RBA, $23.92). Both companies reported results in recent weeks which, not surprisingly, revealed divergent paths:
  • Luxury sales are down significantly and Sotheby's is reducing costs as fast as possible in an effort to conserve cash and, hopefully, service/repay debt. Sotheby's commented that the large revenue decrease was "primarily due to a 71% decline in net auction sales attributable to the downturn in the global economy and its impact on the international art market that began in September 2008." Results can be found here.
  • Used industrial equipment sales are holding their own and Ritchie Bros. is not only seeing record auction results but still growing, albeit slightly. Ritchie noted that "The Company conducted 32 industrial auctions in nine countries throughout North America, Europe, the Middle East and Australia during the first quarter of 2009, and set three regional gross auction proceeds records." Results can be found here.
Although Sotheby's was founded in 1744 and will, no doubt, be around in 2044 (and 2144), we're nervous about the company's trends and weakening financial position (debt load) amidst what could be a prolonged luxury market slowdown. We're not chartists, yet a management "investor briefing" from April 2008 (link here) shows that total auction sales trended lower for four years following the 1999 peak. Lack of forward visibility combined with the company's the debt burden call for caution, in our view.

Ritchie Bros. Auctioneers was founded in 1963 and, at 12/31/08, operated from approximately 110 locations worldwide. Customers "include end-users of equipment, finance companies and banks, truck and equipment dealers, equipment rental companies, and manufacturers." We really like this high margin and high ROE business, which we see as more consistent than that of Sotheby's. We think Ritchie Bros. will also be around in 2044. However, after recovering from recent lows, the stock isn't cheap at 24 times trailing and forward EPS. We plan to keep watching RBA.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: none.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Friday, May 8, 2009

People Are Still Getting Married

Two wedding related companies reported results yesterday: Blue Nile (NILE, $44.58) and The Knot (KNOT, $8.91). Both companies are what we call niche franchise Internet companies and, in our view, have strong competitive positions with asset light business models (that is, they typically require limited capital expenditures to maintain/grow the business). Considering the economic environment, March quarter results weren't bad:
  • Blue Nile reported revenue of $62.4 million, a Y/Y decline of only 11%, while operating income totaled $2.9 million compared to $3.0 million in the prior year quarter.
  • Management signaled that sales trends are improving: “Consistent with last quarter, we are not providing specific financial guidance due to the continued uncertainty surrounding the economic environment and consumer spending. However, on a directional basis, we want to provide some context for our view on the full year. Sales trends improved in the first quarter compared to the fourth quarter of 2008, and we anticipate further improvement as we progress through 2009 with an expectation that the fourth quarter will post a year-over-year sales increase."
  • Results for Blue Nile can be found here.
  • The Knot reported revenues of $23.7 million, only slightly lower than $23.8 million in the prior year period. The sales mix was as follows: "Revenue from online advertising was flat to the prior year’s first quarter as a 4% increase in local online advertising offset a 9% decline in national online advertising revenue. Merchandise revenue from the sale of wedding supplies grew 12%, while registry services revenue declined 3%. Publishing and other revenue declined 11% compared to the first quarter of 2008."
  • Reported operating loss was $2.3 million compared to nearly break-even in the prior year period. Operating expenses were higher Y/Y for a number of reasons. We note that realizing operating leverage is sometimes a challenge for online media companies even in normal economic times.
  • The company is cash rich with cash/investments representing approximately 40% of the company's market capitalization.
  • Results for The Knot can be found here.
So, revenue was down only 11% Y/Y for the leading online diamond retailer (perhaps benefiting from value shoppers) and flat Y/Y for the leading wedding Web portal. These results strike us as fairly good and we highlight as a sign that the sky is not entirely falling.

We don't own shares of either company and, while we see sustainable competitive advantages, valuation is not compelling at first blush: NILE trades at nearly 60 times 2008 earnings while The Knot trades at nearly 70 times 2008 earnings. Even looking at perhaps more normalized earnings from 2007 (when times were good), the companies trade at 43 times and 25 times, respectively. However, if we conclude with confidence that both companies will be (1) around in five years and (2) generating higher revenue, earnings, and excess cash flow because of durable advantages, then we can assign a required rate of return of 10% (discount rate) with perpetual cash flow growth of 3% (inflation, which will arrive at some point).

In this case, valuations are not as egregious: we arrive at a mid- to high $30s valuation for NILE (below current levels) and mid teens for KNOT (above current levels) using 2007 free cash flow figures (assuming the more generous FCF definition of cash flow from operations less capital expenditures as opposed to owner cash flow). However, this assessment can swing widely depending upon assumed cash flow and discount/perpetual growth rates. We plan to keep an eye on The Knot , but prefer to focus on companies trading at a low multiple of current free cash flow such as Youbet.com (UBET, $2.53).


Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long UBET.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Wednesday, May 6, 2009

j2 Global Grows Operating Earnings 18% Y/Y, But Stock is Down?

j2 Global Communications (JCOM, $21.87) was founded in 1995 and provides fax, voicemail, email and call handling services to individuals and businesses worldwide. The company's stock is down 10% today following results yesterday - link here. While revenue was a tad light from Wall Street expectations and subscriber disconnects are trending higher as the recession negatively impacts some customers, the market seems to be overlooking key positives:
  • Revenue still grew 3% Y/Y to $60.4 million (including small acquisition)
  • j2 Global's gross margin improved to 81.1% from 80.2% in 1Q08 and its operating margin was 43.8% versus 38.4% in the year ago period as the company shows continued operating leverage and scale
  • Operating earnings of $26.5 million increased 18% Y/Y and net income was up 11% Y/Y (much lower interest income Y/Y)
  • GAAP EPS of $0.42, up 20% Y/Y from $0.35 (helped by lower share count)
  • Quarterly free cash flow of $30.4 (defined as cash flow from operations less capital expenditures, in this case) was a record for the company, bringing cash and investments to $179.3 million (19% of current market capitalization) - the company has no debt
  • Management maintained guidance for modest revenue and earnings growth this year including acquisitions (which will likely be a small contributor)
and, the real eye catcher:
  • j2 Global's return on net operating assets (RONA) remains extremely high at 82%
Each year, j2 Global generates after tax, cash operating income almost equal to the total amount of capital required to operate the entire business. There are very few companies capable of this feat, period. Moreover, numerous competitive advantages protect j2’s subscription-based, high margin/ROIC business model: brand, sticky customers, scale/scope, and intellectual property rights (59 issued patents). j2 Global should continue to generate significant excess cash that the company can use to further grow the business and return to shareholders through share buybacks.

Many companies are reporting tremendous Y/Y sales and earnings declines, yet their shares move higher.... j2 Global delivers revenue and impressive earnings growth, but shares are lower -- makes no sense to us here at CommonStock$ense, yet the market is often irrational.

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long JCOM.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Tuesday, May 5, 2009

Positive Progress for Sonic Foundry/Mediasite

As a follow-up to our arguably-too-long-for-a-blog post last week on Sonic Foundry (SOFO, $0.75), we'll keep this brief: Sonic Foundry reported F2Q09 results Tuesday (link here) that demonstrate further progress:
  • Revenue of $5.4 million increased 38% Y/Y and cash billings increased 22% Y/Y to $5.5 million
  • Education billings increased 18% Y/Y to $3.3 million and non-EDU billings were up 29% to $2.2 million
  • Gross margin was 75.4% versus 70.6% in the prior year quarter for gross profit of $4.1 million
  • Operating expenses totaled $4.2 million, down 16% Y/Y bringing reported (GAAP) operating income to a modest loss of $144 thousand and reported net income to a loss of $152 thousand
  • Adjusted operating and net income (adding back non-cash items) were approximately $300 thousand
  • TTM revenue totaled $18.6 million (+17% Y/Y), billings were $20.2 million (+13% Y/Y), and, importantly, cash operating loss was only $109 thousand
  • Net cash on balance sheet declined to $1.8 million at 3/31/09 from $2.9 million at 12/31/08 (due to working capital cash consumption to fund top-line growth)
  • Management maintained its forecast for +15-20% revenue growth and positive adjusted net income for fiscal 2009
At approximately 17% of fiscal first half sales, the $2 million deal with King Abdullah University of Science and Technology in Saudi Arabia greatly helped Sonic Foundry, and only $400 thousand remains for F3Q09. For this reason, management likely left the full-year forecast unchanged, which implies only 5% Y/Y revenue growth for the second half at the high-end of the guidance range. For all of the reasons outlined in our first post, we suspect that guidance is conservative. Finally, despite the working capital cash usage, we are comfortable that Sonic Foundry's relationship with Silicon Valley Bank will allow the company to fund cash needs related to growth over the next year.

Conclusion: the Mediasite franchise keeps growing and we believe steady to higher demand for productivity enhancing -- money saving -- software/hardware products such as Mediasite will continue through the recession, whether short or prolonged. For those interested in watching Sonic Foundry's short F2Q call, the link is here.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO.

© 2009 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

Sunday, May 3, 2009

Some Cash Rich Franchise Businesses Still Growing - Not Kidding

Since the painful lows of early March -- when many thought the DOW was most certainly headed to 5,000 -- the market recovered meaningfully. Wow, how quickly things can change. Positive sentiment is creeping back into the American psyche as investors increasingly "look through the valley" of the recession and move beyond the initial shock and awe of the intense selling last fall (much of which, in our view, was driven by fund redemptions and shorts relentlessly piling on downward momentum). Now, the ever-so-slight shift in sentiment is madly squeezing shorts and helping fuel gains for many cyclical companies which were -- until now -- completely decimated (* more regarding the power of a short squeeze in a future post).

Of course, as always, the tug of war will continue between bulls and bears, especially in media, where pundits will debate "when to get back in" and on what sectors to focus (our favorite: "where to make money now"). As natural optimists here at CommonStock$ense, we can envision a scenario where slightly more positive national/global sentiment begets more confident corporations and consumers, which then begets more business investment and consumer spending, which leads to renewed hiring and a gradual recovery. Yet, we can also see a scenario where demand remains constrained into 2010 as unemployment rises and consumers further retrench. Hard, really impossible, to say. We need to acknowledge two things: (1) we're no better at forecasting near-term macro trends than the next guy (who generally isn't very good!), and (2) many companies are still reporting revenue down 15-20% Y/Y, citing weak demand, and further reducing headcount.

Although we're not opposed to purchasing beaten up cyclicals or asset plays where we see both a durable franchise AND a significant margin of safety from normalized values, we feel very comfortable focusing on secular growth franchises that will grow in 2009. More specifically: growing companies that have healthy net cash positions, limited to no debt, and a history of free cash flow generation. With many investors still largely clamoring for cash, we believe owning franchise type businesses that (1) have net cash and (2) generate significant excess cash arguably appear as attractive as simply holding cash, depending upon prevailing valuations in the market (we're seeking high earnings and free cash flow yields).

So, aside from names everyone knows such as Google (GOOG, $401.98) and Amazon (AMZN, $79.77), what cash rich companies are still growing in an economy that is currently contracting at 6% per year? Some examples:

Co-Star Group (CSGP, $36.28)
ComScore (SCOR, $11.50)
e-Health Inc (EHTH, $18.74)
j2 Global Communications (JCOM, $23.95)
Netflix, Inc. (NFLX, $44.94)
PetMed Express (PETS, $16.43)
Sina Corp (SINA, $28.84)
Shanda Interactive (SNDA, $52.43)
SOHU (SOHU, $57.55)
VistaPrint (VPRT, $38.96) * no history of free cash flow generation

To see share prices and other information, please see this nifty consolidation link from NASDAQ.COM here.

Most of these names are Internet companies, which is no surprise given favorable secular growth trends that should persist. Approximately one half are subscription business models, which we especially like at CommonStock$ense. If we had to guess, we believe these companies will be bigger, better, stronger in three to five years (so long as they remain independent). Of the above group, we only own JCOM and SINA at present and, for now, won't comment on which other companies or at what valuations we'd be buyers (saving for future posts, but suffice to say at least some appear fairly valued). Rather we just wanted to point out that some businesses are growing in 2009 despite serious macroeconomic woes that are bringing lower revenue to most businesses that dominate the headlines.

As an aside, we happen to think j2 Global Communications is a fantastic business and the company reports results tomorrow (see link here). While a sell-side analyst downgraded the stock two weeks ago because of the stock's recovery off of the bottom and organic growth concerns, we think j2's high margin, high ROIC subscription business model could surprise Wall Street this year and see incremental upside for the stock.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long JCOM, SINA.

© 2009 Jeffrey Walkenhorst

Friday, May 1, 2009

Mediasite Franchise Value Unrecognized by Market

***All price information is prior to 1 for 10 reverse stock split (completed in November 2009)***

Sonic Foundry (SOFO, $0.71)

Trailing Twelve Month (TTM) Billings (cash collected): $19.2 million
TTM GAAP Revenue: $17.1 million
TTM GAAP Operating Loss: $5.2 million
TTM Cash Operating Loss: $1.1 million (billings less opex adding back restructuring charges, D&A, stock compensation expense)

Market Capitalization: $30.7 million (assuming fully diluted shares of 43.3 million including all options)
Net Cash as of 12/31/08: $2.9 million
Enterprise Value: $27.9 million

Sonic Foundry sells a hardware- and software-based rich media capture solution called Mediasite. As a micro-cap technology company with no history of free cash flow generation, Sonic Foundry is speculative and somewhat akin to a late stage venture capital investment. Moreover, “rich media capture solution” sounds complex and subject to significant competition and technological change, all reasons that often make technology companies bad businesses (and bad investments). However, we’re long the stock for one primary reason: tangible evidence suggests Sonic Foundry’s growing Mediasite franchise is worth multiples of the company’s current market value to an informed private market buyer.

Our confidence arises from several competitive advantages that point to a powerful, sustainable franchise: (1) Sonic Foundry/Mediasite is far along the learning curve with (2) intellectual property protection, and (3) very satisfied, captive customers that face high switching and search costs. Points (1) – (3) are both related to and strengthened by (4) economies of scale and (5) leading market share. Based on these advantages, we estimate a fair value per share range of $1.95 to $2.72 ($2.34 midpoint) today, or more than three times current trading levels (at midpoint). Our analysis is underpinned by favorable near- and long-term fundamentals and an expected inflection point in profitability for fiscal 2009, which mitigate liquidity concerns and should bring a recovery in the share price. Despite positive trends, 286 thousand shares were held short as of 4/15/09, which would require 11 days to cover based on SOFO’s three month average daily trading volume of 26.4 thousand shares.

March quarter results next week: Sonic Foundry reports F2Q09 results Tuesday 5/5/09 after market close with a call at 4:30pm EST: www.sonicfoundry.com/q2 . SOFO is followed by only two sell side analysts who are looking for revenue of $4.5 million (+14.5% Y/Y) and a net loss of $0.03 per share (versus a loss of $0.06 in year ago period). Forecasting for such a small company is difficult and, although our long position is not based on “calling the quarter”, we expect revenue growth of at least 15% and near breakeven cash operating income. We believe results could prove a positive catalyst for the stock.


Company Overview

Sonic Foundry (http://www.sonicfoundry.com/) participates in the emerging web communications marketplace, providing enterprise solutions for more than 1,500 customers in education, business, and government. Mediasite, the company’s core solution, is a patented webcasting platform that automates the recording, management, delivery and search of lectures, online training and briefings. As opposed to simultaneous, group collaboration solutions such as WebEx – which is a different market – Mediasite automatically captures and synchronizes video, audio, and high resolution graphics for one-to-many presentations (e.g. lectures, training sessions, corporate presentations). Importantly, presentations can be viewed live and on-demand immediately following an event without post production.

The Mediasite “solution family” includes:
  • Mediasite Recorders to capture multimedia presentations
  • Mediasite EX Server Platform to stream, archive and manage online presentation content
  • Sonic Foundry Services to provide hosting, event webcasting, training, installation and custom development
  • Mediasite Customer Assurance to provide annual hardware and software maintenance and technical support
Mediasite integrates into (1) content management systems (e.g. Blackboard Learn, Moodle, Angel), directory systems (Microsoft Active Directory and other LDAP directories), room control systems (e.g. Crestron and AMX), and videoconferencing systems (e.g. Polycom, TANDBERG, including telepresence solutions). In addition, Mediasite is part of Dell’s “Intelligent Classroom” – link here.

As of 12/31/08, the company had 3,236 Mediasite Recorders installed in presentation venues around the world “capturing hundreds of thousands of rich media presentation hours” for customers. Including product license, event, and hosting customers, Sonic Foundry’s cumulative Mediasite customer count was 1,509, up 56% Y/Y, with approximately 83% of customers in the product license category. Of product license customers, 49% of customers were in the Education vertical, 35% Corporate, 10% Government, 4% Health, and 2% Other. Of event and hosting customers, 67% were Corporate, 23% Education, 5% Government, 1% Health, 4% Other. Sonic Foundry has a growing list of marquee customers that can be found on the company’s web site here.

Sonic Foundry outsources recorder manufacturing to an electronics manufacturing service provider, which also performs hardware warranty service. To facilitate sales and installation in the United States and abroad, the company utilizes a number of IT integrators.


Backstory

Sonic Foundry was founded in 1991 and is headquartered in Madison, Wisconsin. Until July 2003, the company operated in three segments: Media Services (tape duplication, film restoration for broadcast/entertainment industry), Desktop Software (Sound Forge, ACID and Vegas), and Rich Media (Mediasite). In May and July 2003, respectively, the company completed the sale of the Media Services (approximately $9 million in revenue) and Desktop Software (approximately $16 million in revenue) segments for aggregate cash proceeds of approximately $25 million. Unfortunately, for past investors, the proceeds were well below the company’s $168 million paid in capital and $148 million accumulated deficit at the time (past businesses generated no profits). After repaying certain liabilities, management utilized the proceeds to further develop the nascent Rich Media segment, which Sonic launched after acquiring the base Mediasite technology from Carnegie Mellon University in 2001 for approximately $8 million (nil revenue). For fiscal 2003 ended September, the Rich Media segment generated revenue of only $1.3 million in fiscal 2003. Thus, Sonic Foundry became a publicly traded start-up company.

Since that time, Sonic Foundry increased revenue to $15.6 million in fiscal 2008, although additional capital was required to fund the business and offset operating losses. Paid in capital increased to $184 million as of 12/31/08 (up $16 million over the period) and the accumulated deficit reached approximately $176 million (up $28 million).

Despite gross margins in the mid-70% range, profitability has been elusive for the company for several reasons: (1) costs associated with an expanded service offering in fiscal 2007, (2) an enterprise sales push in fiscal 2007 that failed to ramp as expected, and (3) a product transition that reduced sales in Sonic’s fiscal 1Q08 (end December). Without attaining profitability as promised, management credibility was diminished and investors lost interest in the stock following brief out-performance in calendar 2006.


Management

Sonic Foundry’s current management team has been in place since the 1990s:
  • Rimas P. Buinevicius, age 46, has been Sonic Foundry’s Chairman of the Board since October 1997 and Chief Executive Officer since January 1997.
  • Monty R. Schmidt, age 45, has been Sonic Foundry’s Chief Technology Officer since July 2003 and served as President from March 1994 to July 2003 and as a Director since February 1994.
  • Kenneth A. Minor, age 47, has been Sonic Foundry’s Chief Financial Officer since June 1997, Assistant Secretary from December 1997 to February 2001 and Secretary since February 2001.
Despite the company’s large accumulated deficit and past inability to generate profits through the Media Services and Desktop Software segments, we believe management is (1) capable given relentless, successful efforts to commercialize Mediasite, and (2) highly motivated by inside ownership interests. Also, as described below, we see Mediasite as a valuable, growing franchise that can generate consistent free cash flow over time (i.e. entrepreneurial management finally found the right business). Through direct share ownership and options, management and the board of directors own approximately 19% of the company and insiders made small purchases in recent months.


Financials and Liquidity

The company reports revenue and gross profit results for two segments: Products and Services.

Products: represents sales of Mediasite recorder and Mediasite related products such as server software, which is recognized upon shipment to the customer. Hardware/software pricing is volume dependent and ranges from the high teens (thousands) for a one room system to approximately $10,000 for larger deployments (excluding initial support contracts, which are reported in Services).

Services: represents sales of customer support contacts, as well as Mediasite installation, training, event webcasting, and customer content hosting services. Support contracts are typically for one year with revenue recognized ratably over the contractual period. Installation, training, and event services revenue is recognized when performed, while hosting revenue is recognized ratably over the contract period. Service amounts invoiced to customers in excess of revenue recognized are recorded as deferred revenue until revenue recognition criteria are met.

Sonic Foundry’s fiscal 2008 revenue of $15.6 million was down 7% Y/Y while cash billings of $17.8 million were down 10% Y/Y. Product sales declined 32% Y/Y to $8.5 million (55% of revenue) and Service sales increased 65% to $7.0 million (45% of revenue). The overall Y/Y decline was a result of two primary factors: (1) reduced enterprise sales, partially offset by increased sales to higher education, and (2) lower unit pricing.
  • First, an enterprise-oriented sales push in fiscal 2007 failed to deliver revenue commiserate with costs (salespersons) partially because of a weakening economy, but also because Sonic Foundry discovered that enterprises weren’t keen on making outright system purchases. As a result, the company reduced corporate related sales headcount in early calendar 2008 and decided to emphasize education as its beachhead vertical segment. Any corporate sales efforts were refocused around Sonic Foundry’s event services and hosting offering, which were both launched in fiscal 2007. Although the misstep reveals challenges inherent in nascent technology businesses, the outsourced services model is winning corporate business for the company and a portion of Product revenue shifted into Services revenue in fiscal 2008.
  • Second, Sonic Foundry lowered recorder unit pricing in an effort to expand the Mediasite customer base and footprints at existing customers, negatively impacting top-line growth in fiscal 2008. Total recorder unit sales increased 8% Y/Y to 776, while the implied average selling price declined 18% Y/Y to $11,300. Incremental ASP declines are a key risk factor to monitor.
Sonic Foundry’s gross margin was 73.0% in fiscal 2008, down from 75.3% in fiscal 2007, and the company reported a GAAP operating loss of $5.5 million versus $5.2 million (cash loss of $3.3 million versus $4.0 million).

Management expectations for fiscal 2009: revenue growth of 15 - 20% Y/Y for an implied $18.0 - 18.7 million, gross margin in high 70% range on an increased services contribution, and positive cash flow from operations and cash net income (adding back depreciation and stock based compensation expense). With quarterly cash operating expenses staying relatively flat at $4 million per quarter (per recent results and forward guidance), the implied billings breakeven point is $20.8 million (+ 17% Y/Y).

As of 12/31/08, Sonic Foundry had a cash balance of $3.4 million and debt of $472 thousand for a net cash position of $2.9 million. The debt was outstanding under a maximum $3 million line of credit and $1 million term loan with Silicon Valley Bank with borrowings related to working capital needs to finance growth. On 4/01/09, Sonic renegotiated the terms with Silicon Valley Bank (same 8.75% rate, mixed covenant changes), repaid the $472 thousand, and borrowed the full $1 million term loan. The increased borrowings are likely to fund increased working capital needs entering the seasonally strong education buying period (June and September quarters for US institutions).


Competition

Sonic Foundry faces competition from a number of participants, but most products provide somewhat different applications and may be complementary to Mediasite.
  • Adobe, Cisco (WebEx), Microsoft and Citrix provide web conferencing solutions geared toward group collaboration rather than one-to-many broadcast-like communications enabled by Mediasite.
  • Polycom, Tandberg, Cisco and Sony provide video conferencing solutions that, likewise, are geared for point to point group communications and collaboration. Mediasite integrates with many of these solutions to capture video/audio sessions.
  • Echo360, Tegrity, Accordent Technologies, and Panopto provide presentation authoring and capture solutions. However, based on our research and commentary from Mediasite customers, we agree with Sonic Foundry’s fiscal 2008 10-K conclusion that “these companies currently lack the breadth or depth of content management capabilities required for online multimedia presentations in a campus- or enterprise-wide deployment.” We’re aware of the company winning customers from these competitors (e.g. Temple University from Echo360).
  • Lastly, Sonic Foundry faces competition from internally developed webcasting or lecture capture solutions, although management points out that “many of these organizations are now looking for a solution that requires less internal maintenance and effort, offers comprehensive management capabilities and a less cumbersome workflow.”

Total Addressable Market Opportunity


At present, the rich media webcasting and lecture capture market is a small sliver of a much larger information technology market. Specific to education, the Compass Intelligence U.S. Education IT Market report expected IT spending on products and services to reach $47.7 billion by year-end 2008, growing 4% per year to more than $56 billion by 2012. The firm expected “Internet and electronic learning tools” to account for $9.1 billion in 2008, growing 9% pear year to reach $12.9 billion by 2012. Further, more than half of education CIOs surveyed by Compass Intelligence expect industry growth regardless of overall economic conditions.

On the corporate side, Bersin and Associates published a study in January 2008 that sized the 2007 corporate learning market at $58.5 billion (up 5% Y/Y), including $16.3 billion for external solutions. The firm highlighted that over half of all surveyed companies reported using virtual classroom technologies, with 20 – 30% using application simulation and rapid e-learning tools.

Drilling down, sizing the addressable market for rich media webcasting solutions and lecture capture is difficult given different market definitions and a fragmented marketplace. However, Frost & Sullivan estimated in January 2008 that Sonic Foundry controlled more than 40% of a $25 million market with sales nearly two times that of the market’s second largest vendor. In this case, the research firm defined the market as the “lecture capture and broadcast solutions” and forecast that it would more than quadruple by 2013. Frost and Sullivan information here.

We believe other third party researchers such as Gartner and Wainhouse Research assume larger market sizes with five year compound annual growth rates of approximately 30%. For a third party overview of the market including discussion of Sonic Foundry and Mediasite, please see “Distance Education and e-Learning Landscape” by Wainhouse Research published in November 2008. With permission, Sonic Foundry posted an excerpt that is available here.

Finally, while many universities may use iTunes University or other podcasting solutions,“ lecture capture remains in its infancy despite continued growth in online student enrollments. The 2008 Campus Computing Survey” published in October 2008 by The Campus Computing Project estimated that only 3.1% of classrooms are equipped for lecture capture among all 4-year and 2-year higher education institutions. The 2008 Sloan Survey of Online Learning reported that “over 3.9 million students were taking at least one online course during the fall 2007 term”, with growth of 12% Y/Y well in excess of 1.2% for the overall higher education student population in the United States. The Sloan Survey also reported that more than 20% “of all U.S. higher education students were taking at least one online course in the fall of 2007.” The report can be found here.

Our view: we never like to rely on rosy future forecasts, yet – in this case – we have no problem believing that secular trends will drive healthy growth for leading rich media solution providers. Further, we expect growth across all vertical segments, not only in education, around the world and conclude that the total addressable market for Sonic Foundry is sufficiently large to drive meaningful future growth. However, the key question becomes: does the company have an established, growing franchise that is difficult to replicate and, thus, valuable to an informed private market buyer?


Franchise Analysis


We believe competitive advantages point to powerful, sustainable franchise: (1) far along the learning curve with (2) intellectual property protection, and (3) very satisfied, captive customers that face high switching and search costs. Points (1) – (3) are both related to and strengthened by (4) economies of scale and (5) leading market share.


(1) Sonic Foundry/Mediasite is far along the learning curve

Facts:

  • Mediasite’s development now spans more than a decade since the “technology evolved from a four-year Carnegie Mellon University research effort funded by major government (DARPA, NSF, NASA) and private organizations (CNN, Intel, Boeing, Microsoft, Motorola, Bell Atlantic)” (source: Sonic Foundry’s fiscal 2003 10-K).
  • According to management, approximately $25 million was invested in the effort prior to Sonic Foundry’s acquisition. Since that time, the company invested a cumulative $16 million in research & development and $48 million in marketing & selling to launch multiple iterations of Mediasite into the marketplace. Each time, the company incorporated customer feedback to improve the offering and Sonic Foundry launched version 5.0 in October 2008 with a number of key enhancements. Dramatic improvements occurred on both the front-end (viewer’s experience) and back-end (content management, archiving, search, security, etc.).
  • Improvements also took place on the hardware side: after three years’ development, the company introduced a new proprietary video card, VersaVisual, for Mediasite recorders that support 60 frames per second High Definition video capture. In addition, recorder boxes are ROHS compliant (European Union environmental directive).
  • Mediasite Version 5.1 is slated for release later this year and the company has a clear roadmap for future development (overview included in fiscal 2008 10-K on page 11 here).
  • Sonic Foundry has a complete product/service portfolio that is now generating multiple high margin revenue streams: hardware and software license fees (55% of revenue), as well as support, training, hosting, custom development, and event services (45%). An increasing percentage of revenue is recurring (license, hosting).
  • Many third party audio/video integrators are regularly designing Mediasite into projects around the world, including Media Mission in Europe and Visionaire in the Middle East.
Conclusion: Sonic Foundry’s version/platform upgrades and broad Mediasite offering extend market leadership and further entrench existing customers that are expanding campus footprints. Importantly, an open dialogue with the company’s growing installed customer base establishes a positive feedback loop that accelerates new product development. Moreover, existing customers serve as a positive reference base for potential new customers, leading to a virtuous cycle of expansion and ever larger feedback loop. Thus, the company’s time-to-market advantage, advanced Mediasite solution, and large installed customer/reference base place Sonic Foundry squarely ahead of primary competitors Echo360, Accordent, and Tegrity, all of which have more limited offerings. Quality differences are not lost on current and potential customers. Finally, we believe Sonic Foundry’s high gross margins indicate the proprietary nature of Mediasite technology.


(2) intellectual property protection

Facts:
  • In fall 2006, the U.S. Patent and Trademark Office granted Sonic Foundry its first patent covering a production method and system involving the capture, indexing and synchronization of RGB-based content. The company refers to the patent as “the Mediasite patent” and it will be in force until 2025.
  • Sonic Foundry subsequently was granted one additional patent and, at 9/30/08, had two patents issued and five applications pending.
Conclusion: Intellectual property protection strengthens Sonic Foundry’s competitive position by creating incremental barriers to entry. In addition, the company could pursue licensing opportunities at a future time if sensible to enhance shareholder value.


(3) very satisfied, captive customers that face high switching and search costs
Background:
  • Information technology purchasing cycles can be long and, in higher education, are typically very long. Institutions want to make certain that a solution provides (1) attractive returns on investment, (2) properly integrates with and augments existing systems, and (3) includes reliable customer support as well as a credible roadmap for future development. Benefit to long sales cycle: once a solution is in, it typically stays in.
  • Aside from initial capital investment in the solution and recurring maintenance costs, customers invest time and resources in solution management, operation, and training.
  • Given upfront and ongoing hard and soft costs, institutions find comfort in numbers – as the reference base grows, institutional buy-in becomes easier.
Facts:
  • As noted previously, Sonic Foundry’s customer count was 1,509 at 12/31/08, up 56% Y/Y, including more than 600 higher education customers. The customer count grew in excess of 50% Y/Y for all quarters of fiscal 2008 and fiscal 2007.
  • In fiscal 2008, 59% of billings were to preexisting customers compared to 55% and 50% in fiscal 2007 and 2006, respectively.
  • While total billings for fiscal 2008 declined 10% Y/Y, education billings increased 47% Y/Y in fiscal 2008 to $10.1 million (57% of total billings) and Sonic Foundry completed large, “well into six figure” deals with the Wharton School of Business (University of Pennsylvania), the Ross School of Business (University of Michigan), The Fox School of Business (Temple University), and the Delta Group (North Carolina State).
  • For fiscal 2009, Sonic Foundry announced the largest deal in company history: “150+ fully enabled lecture capture classrooms” for $2+ million over three quarters at the new King Abdullah University of Science and Technology in Saudi Arabia (link here) .
  • Sonic Foundry has a growing user group that facilitates information exchange among customers (link here). In addition, the company hosted its third annual user group conference this week with approximately 230 attendees (+15% Y/Y) from 28 states and eight countries (link here).
  • Customers consistently report extremely high satisfaction with the solution, as well as rapid paybacks and high returns on investment. Users further indicate that Mediasite is greatly improving communications and saving/making money at their respective organizations. Customer quotes are available here.
  • “Mediasite” is becoming a verb as customers/users simply say, “Mediasite it”.
  • Independent research by Mediasite customers reveals improved grades and an overwhelming preference for access to live/on-demand Webcasts, with students willing to pay incremental fees for the service.
  • Sonic Foundry announced winners of the Fifth Annual Rich Media Impact Awards this week (link here). One of the winners was Penn State Hershey Medical School. For a six minute summary of how the school uses Mediasite, please see link here.
  • For a University CIO’s perspective (23 minutes) - link here.
    Building the Mediasite Enterprise: How the University of Maryland, Baltimore Developed the Infrastructure and Consensus for Campus-wide Lecture Capture
    Dr. Peter Murray, VP and CIO of the University of Maryland, Baltimore
Conclusion: Related to point (1), as the existing user base grows, Mediasite is becoming the de facto global standard for rich media capture, which propels the positive virtuous cycle of both mainstream market adoption and continuous product improvement. Moreover, as customers structurally embed Mediasite in their infrastructure, they invest more resources in hard and soft costs that, therefore, create a captive customer base for Sonic Foundry. Usage habits are reinforced and switching costs increase. In addition, search costs – looking for an alternative solution – grow more expensive and increasingly less attractive after investing resources in Mediasite (not to mention high satisfaction with the product).


(4) economies of scale
Facts:
  • Years of expenditure for development and marketing initiatives can be capitalized through increased volumes resulting from mainstream market acceptance and adoption.
  • Operating leverage kicks in and the average cost per incremental sale declines as volumes increase.
  • A Yahoo! search for “Mediasite Presentation Catalog” uncovers more than 30,000 catalogs (potentially explained by some customers having multiple catalogs and/or product trials) -- link here.
Conclusion: As the licensed customer base grows, Sonic Foundry should become more like a traditional software company with steady stream of revenue from support/maintenance license renewals. We believe annual renewal rates are 80 - 90% with contract fees approximately 20% of initial purchase cost. The service segment should also benefit from increased scale, especially the hosting business. With Sonic Foundry's heavy lifting complete and operating expense growth limited (or flat Y/Y), operating leverage should enable meaningful free cash flow generation on a prospective basis.


(5) leading market share

While determining market share is a challenge primarily because of different market definitions, the consensus view among third party researchers is that Sonic Foundry is the share leader with perhaps 40-50%.
Facts:
  • To drive awareness, Sonic Foundry hosts a webinar series where Mediasite users share “best practices for using lecture capture to bridge time and distance, accelerate research and improve academic performance.” The Webinars are reaching an increasing number of viewers around the globe (link here).
  • A recent webinar featuring Villanova University had live viewers from the following countries: Australia, Belgium, Belize, Brazil, Colombia, France, Germany, Ireland, Italy, Norway, Spain, The Netherlands, United Kingdom, Japan, Kuwait, Saudi Arabia, Syria, United Arab Emirates, South Africa, Tunisia, Pakistan, and Puerto Rico. In addition, all provinces of Canada were represented and all US states except Delaware and South Dakota.
  • Industry recognition – 2008 awards (link here)
  • Best Presentation Tool - Elearning Magazine Best of Elearning! Awards
  • Best Mobile Learning Tool - Mediasite Podcast, Elearning Magazine Best of Elearning! Awards
  • Best Virtual Classroom - Elearning Magazine Best of Elearning! Award of Excellence
  • Best Web Seminar Solution - Elearning Magazine Best of Elearning! Award of Excellence
  • Best Webcasting Platform - Streaming Media Magazine Readers Choice Awards
  • Learning Impact Leadership Award, lecture capture at Villanova University with Mediasite - IMS Global Learning Consortium
  • Excellence in Teaching for Online Distance Learning Award, York University Professor Diane Zorn for online philosophy course with Mediasite - United States Distance Learning Association
  • Fast 500 Winner - Deloitte's 2008 Technology Fast 500
Conclusion: Mediasite is increasingly recognized worldwide as the best-in-class “utility” for Webcasting, driving awareness and adoption by more and more organizations. As a result, Sonic Foundry’s is well placed to remain the market share leader.


Fundamentals


The company’s woebegone share price and history of operating losses mask a number of favorable developments over the past year:
  • Increased focus on the education vertical is leading to renewed top-line growth in fiscal 2009 as the book of business laps fiscal 2008’s significantly reduced non-education sales. Education billings grew 47% Y/Y in fiscal 2008 and tripled Y/Y in F1Q09. Sales growth could accelerate in fiscal 2010 as education contributes an even larger portion of sales.
  • Large-scale deployments are increasing for reasons noted in the franchise analysis section. Also, increased market and government focus on (1) education to counter the recession and (2) green initiatives are favorable trends.
  • Repeat product business is high as are renewal rates for support/maintenance contracts.
  • The business model was right-sized to achieve operating leverage and sustainable cash profitability going forward. On a TTM basis, Sonic Foundry’s cash operating loss was $1.1 million for the twelve months ended 12/31/08 compared to a loss of $5.2 million in the prior year period, implying that balance sheet net cash of $2.9 million is sufficient to fund operations for approximately 2.6 years if growth stalls out (which we believe is unlikely for aforementioned reasons).
  • Deferred services revenue is building on Sonic Foundry’s balance sheet and totaled $4.6 million at 12/31/08 (+44% Y/Y) excluding approximately $1.8 million of additional purchase commitments from King Abdullah University.

Reproduction Value – Valuing a Technology Company with No History of Profitability


Our estimate of fair value is derived from an estimate of reproduction value plus a control premium for Sonic Foundry. Assuming Mediasite can be replicated, we estimate that a new entrant would need to spend $67 million, or $1.56 per share (base case), to create the solution. Adding a 50% control premium that an informed private market buyer might pay to acquire the company, we arrive at a fair value of $2.34 per share.

Since acquiring the base Mediasite technology from Carnegie Mellon University in 2001, Sonic Foundry spent approximately $16 million in research and development to prepare Mediasite for market and advance the technology (Versions 1.0 – 5.0). In addition, Sonic spent approximately $48 million in marketing and selling to trail blaze the new market by proving the product, winning customers, developing the brand, and – finally – attaining widespread recognition and adoption.

If we assume a new entrant would need to spend five years of Sonic’s historic R&D and M&S expenditures to replicate the Mediasite asset, we arrive at an adjusted book value per share of $1.56, nearly two times SOFO’s 4/30/09 closing price of $0.71. This estimate includes Sonic Foundry’s 12/31/08 book value per share of $8.5 million, $7.6 million of which is goodwill related to Mediasite (a large discount from the $25 million invested in the technology prior to Sonic Foundry’s acquisition).

Beyond the implied $1.56 value, an informed buyer would need to pay a reasonable control premium to gain full ownership of the franchise. If we assume 50% (highly subjective), the implied value rises to $2.34, or approximately five times estimated fiscal 2009 revenue of $18.6 million. A 25% premium implies $1.95 per share, while 75% implies $2.72, both of which provide a large margin of safety from trading current levels.


The above analysis assumes that the Mediasite technology can be reproduced. However, while competitors Echo360, Accordent, and Tegrity have tried to follow Sonic for years, their product offerings are not comparable to Mediasite’s elegant, automated synchronization of rich media content. Samples for each, click: Echo360, Accordent, and Tegrity.

As a result, not only do Mediasite customers face high switching/search costs after investing in the solution, but – in our view – no real, competitive alternative (substitute) exists at present.

Lastly, our research implies that Mediasite customers are diehard to the point of fanaticism about how Mediasite is improving productivity within their organizations. As such, customers become voluntary evangelists on behalf of Sonic Foundry and, therefore, drive incremental penetration. These intangibles are extremely difficult to replicate by simply spending millions of dollars in marketing and selling.

Conclusion: Sonic Foundry’s increasingly entrenched market position might suggest an additional purchase price premium, bringing an informed buyer to pay more than five times revenue.

Informed buyers could include any number of large technology original equipment manufacturers (OEMs) including Cisco, IBM, HP, Dell, Tandberg, Polycom, and Blackboard. Nearly all of the large players face slowing growth in their core businesses and, with large net cash positions, are on the hunt for growth areas with sizable addressable markets. Specifically, Cisco is pursuing a “’build, buy, and partner’ innovation strategy to move quickly into new markets and capture key market transitions” and, in 2007, paid approximately seven times trailing revenue for WebEx. While deal flow has slowed and multiples have compressed in the current environment, software-as-a-service companies as a group are currently trading at an average enterprise value to sales multiple of 2.6 times (no control premium).


Key Risk Factors


Although we feel risk factors are mitigated by favorable fundamentals and our franchise value analysis, key risks include: history of operating losses, cash burn, small size, competition, technological change, illiquid stock, and potential Nasdaq delisting (deadline in September 2009 to meet minimum $1 requirement).


Conclusion
Our franchise analysis provides us with comfort that, through Mediasite, management created an asset that is extremely difficult to replicate and, therefore, very valuable. While assessing the value is not straightforward since Sonic Foundry is just now reaching a free cash flow inflection point, estimated reproduction cost plus a reasonable control premium imply a significant margin of safety above current trading levels. Whether Sonic Foundry remains a stand-alone company or is acquired at some future point, it strikes us at CommonStock$ense that shares of the company should move smartly higher as Mediasite adoption gains increasing momentum around the world.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: Long SOFO

© 2009 Jeffrey Walkenhorst