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Friday, January 29, 2010

Sonic Foundry Delivers and Reiterates Guidance; Large Deals Becoming Reality

After Sonic Foundry's (SOFO, $5.40) fiscal 2009 report last November, our post was "To Believe or Not to Believe (in the Mediasite Franchise)?" (link here). Readers probably know by now that our research provides ample evidence to believe in the franchise. We included more support for the franchise thesis earlier this week (here). Still, ultimately the financial results must confirm the presence and durability of a franchise.

We think fiscal 1Q 2010 results released yesterday are another step in the right direction and -- importantly -- forward guidance for a "tipping point" (as coined by author Malcolm Gladwell) this year remains intact. In fact, management said we'll begin to see "large deal impact" during the March quarter (fiscal 2Q 2010). This is ahead of prior guidance calling for large deals to hit late spring and summer (June/September quarters). We recommend watching the half hour presentation - link here.

An interesting sidebar (pointed out by someone on the Yahoo! Finance Message Board here) is to watch Sonic Foundry's earnings Webcast and compare the Mediasite delivery to that of video conferencing giant Polycom's recent earnings Webcast (PLCM, $22.48) - link here. Polycom uses a pop-up window with video playback via user selected Windows Media or Real Player that has a slide window to the right. Yet, the slides didn't move for us. Instead, to share/show each new slide, a new browser window is launched each time (!!!), which -- to put frankly -- we find cumbersome and suboptimal. We suspect Polycom management would not only agree but likely prefer to use Mediasite to deliver their quarterly message (and other corporate events). Thus, as discussed in our "Get the Memo" post on 1/03/09, Polycom provides us with yet another example of an organization that needs Mediasite, albeit one sitting squarely in the video arena.

Back to results. For the quarter, revenue of $4.5 million (+12% Y/Y) was better than implied guidance for only $4.0 million and the company's GAAP net loss was only $320 thousand compared to $1.3 million (revised) in the year ago period.

Sonic's trailing twelve month income statement is as follows:
  • Billings of $19.5 million were up 1% Y/Y (expect acceleration in coming quarters)
  • Revenue of $19.1 was up 12% (catching up to TTM billings)
  • Gross profit of $14.6 million was up 16% (margin expansion)
  • GAAP operating expenses of $16.1 million were down 10% (expense reduction)
  • Cash operating income of approximately negative $150 thousand (a $900 thousand Y/Y improvement)
Looking at the balance sheet: deferred revenue at 12/31/09 increased 10% Y/Y to $5.04 million, total debt increased to $1.01 million from $529 thousand a year ago, and net cash declined by $1.6 million to approximately $1.27M (total cash was $2.4 million). Net cash was down only $157 thousand Q/Q as positive working capital helped offset the company's modest operating loss. Management again noted that debt will increase to fund anticipated working capital needs to support large deals expected in coming months that should drive rapid top-line growth. Then, meaningful positive cash flow should arrive, improving the company's net cash position.

A few slide highlights - new customers:

Guidance:
More on the outlook and market position:
In Crossing the Chasm: Marketing and Selling Disruptive Products to Mainstream Customers by Geoffrey Moore (included in our reading list here), Mr. Moore shares his view of the technology adoption life cycle and strategies for making the jump -- i.e. "crossing the chasm" -- from "Early Adopters" to "Early Majority" and then to the "Late Majority". Mr. Moore's advisory firm, TCG Advisors, includes several related presentations on its Web site (link here).

In one deck,
Dealing With Darwin - Innovation Vectors TCG Advisors Deck, he illustrates the life cycle with a "bowling alley" and "tornado" in the "Early Majority" phase as adoption accelerates on the way to "Main Street" adoption. Given Sonic Foundry's guidance and apparent confidence that the large deals are in process (i.e. a reality), we think Mediasite is currently making the leap to mainstream adoption. Of course, execution is critical during this stage and, along with IT budget pressures, represents a primary risk factor.

Let's briefly consider two scenarios:
  • (1) The best case scenario for investors: earnings power finally becomes material in calendar 2010, although the Market (today) may not believe the future promise until micro-cap Sonic truly shows it the money (within next six months). At that point, interest in "the story" suddenly perks up and valuation expands along with investor/media interest. We've seen it before with other companies. If quarterly revenue can scale to the mid-$6 million range, we estimate quarterly earnings of around $0.25, or approximately one dollar annualized. At that level, even a conservative P/E multiple puts shares meaningfully higher.
  • (2) The worst case scenario: large deals fail to materialize and the business trends flat and/or erodes and funding is a problem in a still fragile economy. The stock languishes and declines.
Which scenario is most likely? Per our "Which Way from Here" presentation, we quickly admit that short-term forecasting is a fool's game. Also, traditional value investors might pass over Sonic Foundry given a history of operating losses and a small net cash position (limited margin of safety, at first blush). We acknowledge that our ownership stake falls into the speculative camp and, as noted in the past, we consider our investment somewhat akin to late stage venture capital.

However, we find comfort through our extensive technology industry experience and Mediasite franchise analysis.
Notably, we see and hear increasing, consistent, and favorable feedback from customers -- for the latest, please see the Big Bend Webinar this week:

Getting the Buy-In and Budget to Launch Hybrid Courses Right Now

Getting the Buy-In and Budget to Launch Hybrid Courses Right Now

Russell Beard of Big Bend Community College shows you how one of the smallest community colleges in the state of Washington with one of the largest service districts – 4,000 students across 4,500 square miles – found the money, time and political will to launch a webcasting program.


While acknowledging risk factors, we can now feel even better with our November conclusion on the back of reiterated guidance -- 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.

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 based on trailing financial results (without the benefit of insights into Sonic's pipeline that might support a higher "PMV", 2009 M&A comps provide support).

We will follow-up in February with a bit more on how to interpret forward guidance.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO.

© 2010 Jeffrey Walkenhorst
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4 comments:

  1. Jeff thank you for your excellent analysis and the blog is great. Just a quick question. If SOFO's revenues ramp like you think they will, will the company sacrafice profitability to grow the top line? Also can you see them trying to raise capital through any type of equity offering?

    ReplyDelete
  2. Hello Anonymous, thanks for reading and for your kind words. Answers:

    (1) I think management is committed to keeping expenses in check and understands the importance of delivering consistent, positive earnings and cash flow on an annual basis. Recurring service revenue is a key component of delivering predictable, stable results, and large platform deals should grow this segment for Sonic.

    My understanding is that the current cost structure (staff) is largely sufficient to support anticipated large deals this year and that viral marketing through the user group and monthly Webinars is helping on the marketing front. I think Sonic is increasingly relying on channel partners for sales and installation support. BTW, this is another part of my franchise thesis: Sonic/Mediasite is evermore popular among A/V channel partners because the solution works so well right out of the box and, with a large reference customer base, is a relatively easy sale = barrier to entry as Mediasite is go-to solution. Recall what I relayed on 7/30/09 (A/V channel plus other aspects of franchise):

    "The key focal point for us remains the Mediasite franchise, which we believe continues to grow in value as customers expand footprints, new customers join the community, and -- importantly -- the global A/V channel increasingly recommends Mediasite for rich media Webcasting. We think the channel promotes Mediasite because the solution works extremely well, is reliable, and has a clear product development road-map. The growing, installed customer base, combined with brand recognition, trust, and global distribution, are all difficult for a competitor to replicate and take years to establish. In our view, these aspects mitigate the risk of rapid technological change and help secure Mediasite's leading position in the marketplace."

    AND, what I relayed in my initial SOFO post -- typical software business model:

    "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."

    Thus, expenses should remain under control - i.e. below $4 million per quarter over the next year. At some point, however, if the business scales markedly, I can envision higher marketing expense to help drive even more sales. We'll see. Overall, I believe the potential for significant operating leverage is very real and that the heavy lifting is largely complete. If these sales materialize, a large portion should drop the the bottom-line, especially since net operating taxes losses should shield cash taxes for many years.

    (2) If growth is as expected/guided by management, positive cash flow should increase liquidity later this year and the business should become self-funding. Under this scenario, I don't see any need for incremental equity capital in the near-term. I see potential equity offerings under two scenarios: (1) the company delivers in coming quarters and the share price recovers meaningfully (e.g. high teens, $20s or even $30s - impossible to predict with certainty) and Sonic decides to issue some equity to bolster the balance sheet (eliminate all debt with excess cash left over); or (2) if the downside scenario (per my blog post) comes to pass and Sonic is up against a wall with debt financing no longer available. I see the latter scenario as a low probability event.

    Br,
    Jeff

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  3. Thanks Jeff. Sorry about Anonymous. I was having a problem posting and it was just easier to do that. What are you modeling for sales growth this year? I think they are selling at 1x sales now.

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  4. Hello Jim,

    It's extremely hard to forecast with certainty given the small size of the company and the uncertain size of pending "large" deals, but here's how I think about potential FY10 revenue:

    - layer on a reasonable approximation of large deal billings/revenue on top of FY09 billings of $19.2 million
    - assume the $19.2 million recurs - while not quite one half of that revenue is actually recurring, assume existing customers expand footprints to again generate comparable "base" revenue in FY10
    - then, considering the new deals -- "half dozen" at $500K to $2 million+ per conference call - to be conservative, assume only 3 or 4 hit in FY10 with perhaps an average size of $1 million in FY10 = $3.5 million of incremental billings/revenue + $19.2 million = $22.7 million total billings, or 18% Y/Y growth on conservative side. We'll see what they deliver.
    - My preference is to focus on cash flow or earnings based valuations, yet price to sales can work for a business at this stage of development. My research suggests that "comparable" M&A transactions have occurred anywhere from 3-6x sales, with the lower-end more applicable for mature businesses and the upper end more applicable for faster growing businesses. In my view, SOFO's current valuation of ~1x sales offers no value for the Mediasite franchise and a likely acquirer would probably be willing to pay at least several multiples of this level.

    Br,
    Jeff

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