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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.


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.


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).


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


  • 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

  • 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
  • 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.
  • 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
  • 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%.
  • 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.


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).

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

Disclosure: Long SOFO

© 2009 Jeffrey Walkenhorst

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