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Tuesday, November 3, 2009

Sonic Foundry Removes Key Overhang - Now, Market Can/Should Focus on Results

After market close Monday, Sonic Foundry (SOFO, $0.64) announced a Board decision to effect a one-for-ten reverse stock split of its common stock on 11/16/09. In our view, we believe the Board made the decisions for a number of reasons, including:
  1. preemptive action to prevent shares from being de-listed from the NASDAQ should the stock remain below the $1.00 minimum bid price by the 12/21/09 deadline. Per our prior posts, Sonic Foundry has shown considerable progress over the past year, yet the Market has not noticed. Thus, even if Sonic Foundry meets FY09 (end September) guidance for >20% revenue growth and cash profitability, the stock may well remain stuck below the $1.00 requirement and face de-listing. We think the Board wants to eliminate this negative risk (although de-listing isn't necessarily the end of the world as we have seen some OTC companies thrive and ultimately re-list over the past decade).
  2. remove overhang associated with #1 that keeps some investors out of the stock.
  3. remove negative stigma associated with trading below $1.00, from both an investor and a business (customer) perspective.
  4. establish new trading price in mid- to high single digits ($6-7 based on current levels) that is above $5 minimum requirement for some investment funds.
  5. potentially reduce the large absolute number of shareholders who hold fewer than ten shares by not allowing fractional shares to be issued to such holders (*per 10-K, at 12/3/08, Sonic Foundry had approximately 9,000 shareholders, an exceptional number for such a small company that increases public company expense).
  6. improve perceived earnings per share power (although market capitalization will be unchanged) -- by taking fully diluted shares from approximately 43 million (including all options) to 4.3 million, Sonic Foundry could report earnings of $1.00 per share IF net income is $4.3 million (looking out). Depending upon Mr. Market's appetite for high growth, niche technology companies, a forward multiple of 20-30 times this figure would imply a share price of $20-30.
The above reasons appear sensible and are not all-inclusive. One potential negative is that an already illiquid stock could become less liquid with a free float that will be 10 times smaller than current levels. As noted previously, we were encouraged in recent months by increased trading volume and renewed institutional buying. Nonetheless, perhaps the new price range will attract additional investor interest and lead to a more active market for the stock.

We are aware of another technology company, KIT digital (KITD, $9.26) that effected a one for 35 reverse split in March and currently averages 43 thousand shares per day on a float of only 2.8 million shares (per Yahoo! Finance here). KIT digital also happens to be in the Web video realm, but is not a direct competitor to Sonic Foundry.

We emphasize that nothing has changed fundamentally. Changing the share count and share price through a split are essentially smoke and mirrors for any company -- all ownership stakes, large and small, remain exactly the same. What matters above all is a company's ability to generate a growing stream of free cash flow that can be used in a shareholder friendly manner.

While we classify Sonic Foundry as a speculative, venture capital-like position in our portfolio, we continue to believe that the company is at the free cash flow inflection point and could generate one million of excess cash flow over the next year if growth remains similar to fiscal 2009 (key risk factor: public/private school budget woes). Moreover, we believe the franchise value to an informed private market buyer remains significantly higher than current levels.

If management fails to deliver on guidance for the September quarter and the fiscal 2010 outlook runs contrary to our current free cash flow forecast, we will be disappointed and forced to reassess our thesis. However, from what we can tell, the Mediasite franchise continues to grow nicely. We'll share more details in coming weeks.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO.

© 2009 Jeffrey Walkenhorst
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