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Monday, November 30, 2009

Sonic Foundry: To Believe or Not to Believe (in the Mediasite Franchise)?

Sonic Foundry (SOFOD, $5.40) reported fiscal 2009 results today after market close -- link here (includes Mediasite Webcast). Here are some brief points:
  • The company made great strides expanding gross margins and reducing expenses, although full year revenue of $18.6 million (+19.2% Y/Y) came in lower than our expectations and just shy of previously raised guidance calling for >20% top-line growth.
  • Other key metrics also exhibited slower growth: billings of $19.2 million increased only 13.6% Y/Y (not adjusted for slight shift at year-end fiscal 2008) and deferred revenue of $5.3 million increased only 13.1% Y/Y.
  • Lower-than-expected revenue led to a slight cash operating loss for the year of approximately $700 thousand, compared to earlier guidance for full-year cash profitability.
  • Fortunately, cash burn is under control: Sonic Foundry ended the year (9/30/09) with a net cash position of $1.43 million, down from $2.93 million one year earlier (= burn of $1.50 million), but up from $1.25 million at 6/30/09.
  • Some good news: management implied that the revenue "tipping point" is finally upon us. From the press release:
  • “Furthermore, we are beginning to see signs of economic recovery, and specifically, certain signals for expanded growth in mid-2010 as they relate to the Mediasite product and service offering. Correspondingly, our recent prospecting has resulted in additions to our sales pipeline that, if consummated, would dwarf most of the previous sales made by the company to date. These opportunities have been harvested both domestically and internationally and in different vertical segments of our customer base, most of it occurring in the last few months. Based on the expected timing of these new opportunities, mid-2010 may mark a significant turning point for the company, which could substantially expand operating performance, especially given the cost reductions and operating leverage now in place."
We are disappointed by the slight revenue shortfall and continuing operating losses, but cognizant that (1) Sonic Foundry operates in an "emerging" market where forecasting is a challenge and (2) we're in a recession that is crimping IT budgets everywhere. With regard to the latter point, we note that Polycom (PLCM) -- a much larger company but decent proxy for video/audio conferencing systems -- reported revenue down 12% Y/Y for the most recent quarter.

Per our post's title, let's borrow from Hamlet's "To be or not to be" question to ask a related, similar question: to believe or not to believe in the rosy outlook? In this regard, the real question is: do we believe in the Mediasite franchise and management's ability to deliver shareholder value?

Let's look at several slides from the management presentation to provide context:

Customer sampling, including new wins during fiscal 2009:

Potential operating leverage:
Quarterly guidance:
Now, let's review some commentary we added to the comments chain below our recent SeekingAlpha post (slightly modified herein):
  • ... Accordent won the Enterprise Video Platform award, which is a positive for that company and indicates favorable traction. However, Sonic also plays in that arena and has solid mind-share. For reference, please see this Streaming Media article, "Navigating the Enterprise Video Workflow", which highlights four major companies: Computer Associates, Lockheed Martin, Merck, and QAD. Of the four, three use Mediasite and only Merck uses Accordent.
  • Mediasite is far more than simply hardware - there is a major software element, along with service/support. Combined, it's far from commoditized as indicated by gross margins in the mid to high 70% range. Personally, [we're] focused on buying franchise type companies that have multiple competitive advantages and are inherently NOT commodity businesses. Technology companies are often poor investments because of rapid change/competition, yet Sonic Foundry's large and growing installed customer base suggests Mediasite isn't going anywhere anytime soon.
  • Importantly, operating margins and ROE are poised to move from "not meaningful" to "meaningful" as the business crosses a cash flow inflection point and generates positive net income. Acknowledging that the business (and sector) is (are) nascent with sometimes "lumpy" revenue, forecasting can be a challenge. Assuming forward net income of only $2 million would yield an ROE of approximately 20%.
  • [In a sense,] the split had nothing to do with shareholders - likely reasons were detailed in [our] prior posts, with customer perception no doubt very high on the list. Note that shorts can still easily get squeezed since volume is so light (short ratio same pre/post split). If Sonic puts up good numbers Monday, the stock could "gap" higher and others should take notice. Expectations are extremely low.
  • Growing top-line ~20% in a recession isn't too bad. Otherwise, we'd probably be seeing 30-40% Y/Y.
  • All investments carry risk and SOFOD is an illiquid microcap, which carries even more risk. The key is to mitigate risk factors and not bet on "luck". If [we're] wrong and positive free cash flow doesn't arrive as expected, [we] will change [our] tune.
To conclude: while SOFO is not our usual cash rich or dividend paying investment fare, our interest in Sonic Foundry is derived from our extensive technology industry experience. Furthermore, our intrinsic value estimate of $20-27 is supported by an estimate of reproduction cost as well as the probable private market value that would be awarded by an informed strategic buyer (*recent M&A comps provide support). Given the company's expanding customer roster and forthcoming campus-wide adoptions, we continue to believe our initial thesis: competitive advantages point to a powerful, sustainable franchise -- Sonic Foundry is (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.

One more point: since management signaled (1) multiple, highly probable large-scale deals that would apparently be game changing in terms of Sonic Foundry's financial profile and (2) meaningful undervaluation by the Market based on M&A comps (which we discussed previously), we think it's only reasonable that insiders step up to purchase shares (even if they can afford only a few thousand shares because of the difficult times). Such action would add credibility to the bullish outlook and, thereby, provide confidence to the Market. We will be disappointed if we see no insider purchases in coming weeks.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFOD.

© 2009 Jeffrey Walkenhorst
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3 comments:

  1. Jeffrey, thanks for the plug for my article "Navigating the Enterprise Video Workflow", from the most recent Streaming Media magazine, which highlights four major companies: Computer Associates, Lockheed Martin, Merck, and QAD.

    While you are correct that three of the companies mentioned in the article use MediaSite, I don't think you'd want to use that as a litmus test for how Accordent and SonicFoundry fare in the enterprise space, based on three reasons:

    First, choosing enterprise companies to talk to on record is completely different than companies that are willing to talk off-the-record, which in itself is different from companies who are willing to give a sentence or two but no more. In my twenty years in integration design and consulting, I've done work for multiple enterprise clients who won't allow a press release or use of their logo on a client sheet, but it doesn't negate the fact that I've done work for them (and that they'll provide private references when asked). Part of the equation has to do with the PR/marketing department finding companies willing to speak on the record and get approval in a limited timeframe, so I would equate it to the analogy of figuring out which cars are selling best by standing on the sidewalk and sampling the first ten cars that go by . . .

    Second, you'll may have also seen that one of the three MediaSite-centric enterprises uses the product within a particular division of the company, adding that other solutions are used in other divisions. That's a key point that I did not stress in the article, but I often find a large enterprise using several solutions, including competing and/or homegrown solutions, across the various divisions or business units.

    Third, and I touched on this briefly in the article, the solutions that are in place today in some of these enterprise customers have, for the most part, been in place for five-eight years. They work, they don't break and they could probably keep working for the next decade. There are impending inflection points that will re-open the market to further re-assessment of total solutions, which may benefit Sonic, Accordent and others.

    To use one example, the fact Windows Media encoding / decoding solutions form the core of the early solutions has been a non-issue until Microsoft's recent more toward Silverlight. The ability of Silverlight (or of Flash, for that matter) to yield a more flexible player / multi-pane viewing solution versus the relatively static options available a few years ago may be compelling enough to force enterprise managers to relook more than just the format that they've used in the past.

    Hope that's helpful clarification to my article, without disparaging any vendor or end-user company that was part of the interview process and subsequent write-up. Thanks again for the plug for the article.

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  2. Hello Tim, thank you for your insightful comments, feedback, and article(s) -- much appreciated. You raise very good points.

    I always try to be balanced in my research and should have mentioned potential sampling bias in my "three to one" comparison. You are correct that many companies don't talk publicly about internal IT solutions/apps, so the fact that three raised their hand and happened to use Mediasite may not be illustrative of overall market share. In this case, I was simply highlighting that Sonic Foundry also has "solid mind-share" in the enterprise realm alongside Accordent (which clearly has a following given the Enterprise Video Platform award).

    Each solution has different merits and, as you point out, many organizations may use different products in different business units. Of course, over time, my expectation is that more organizations will move to a central IT video platform, much as we've seen in other areas of IT (e.g. business units moving from "silo" servers to shared servers for an entire enterprise = more efficient, lower total cost of ownership, etc.).

    That said, when it comes to rich media webcasting and lecture/conference capture, my ongoing research implies that Sonic Foundry remains the market leader with a robust offering and road-map.

    Thanks again and I look forward to following your work.

    Jeff

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