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Wednesday, March 3, 2010

Sonic Foundry Thesis Revisited - Scenario Analysis and Potential Valuation

In our post the other day, we mentioned that Sonic Foundry (SOFO, $6.80) might be trading at only six or seven times forward earnings for the year beginning this summer. In this post, we explain our analysis in a summary thesis we've shared with institutional investors in recent months.

Before jumping into our analysis, we thought we'd relay something quite surprising (but potentially helpful to Sonic Foundry shareholders): the latest SOFO short interest report from Nasdaq.com:

SO, despite posting better-than-expected results for the December quarter and raising guidance ("begin to see impact of large deals in March quarter"), short interest actually increased slightly in the latest period to 31.7 thousand shares (as of 2/12/10). "S/I" now represents approximately 10% of Sonic Foundry's estimated "float" of 3.02 million (per Yahoo! Finance). While not overly large (e.g. see Netflix's S/I at approximately 31% of float per Yahoo! Finance), the number is not insignificant and we think the real percentage is even higher than 10% acknowledging blocks of shares held by other long-time holders that, like us, believe in the growing Mediasite franchise.

[CORRECTION! - an astute reader correctly pointed out that the S/I is only 1%, not 10% -- my mistake. As noted in my response to the reader, we're not sure what planet we were on when previously making the calculation and subsequently publishing....]

For reasons described below, we see "shorts" betting on a decline in Sonic Foundry's share price as being in a highly precarious position. We expect shorts will need to cover their positions by purchasing shares. We suspect such covering could lead to very favorable upward moves in illiquid SOFO shares.

SUMMARY THESIS AND ANALYSIS (familiar to many regular readers, except for our forecast analysis)

Sonic Foundry (SOFO, $6.80, $29.9 million MC, $28.6 million EV - assuming fully diluted shares of 4.4 million; pricing as of 3/2/10)
  • Sonic Foundry sells a hardware- and software-based “rich media” Webcasting solution called Mediasite.
  • The Mediasite solution is a comprehensive platform technology that effectively addresses a clearly defined market need and can scale into a large global market. With a large, growing, and happy installed customer base, Mediasite is increasingly recognized as best-in-class and is emerging as the de facto global standard for lecture capture and Webcasting.
  • Several competitive advantages point to a powerful, sustainable: (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.
  • Despite tangible evidence of an established franchise, the company is trading at only 1.6x trailing twelve month (through December) sales of $19.1 million (+12% Y/Y) because of a history of operating losses (though shrinking) and the company’s small size.
  • However, an inflection point is now visible as management pointed to a “half dozen”, highly probable large-scale deals in mid-2010 that would be game changing in terms of Sonic Foundry's financial profile.
  • While no specific guidance was provided, layering in only several larger deals (assume $1 - 3 million each over several quarters) on top of Sonic Foundry’s existing book of business implies that annual revenue could scale from approximately $19 million to $25 - $30 million for the 12 months beginning in mid-2010 and ending in mid-2011.
  • Applying a conservative 75% gross margin (versus 77% in fiscal 2009) to revenue of $26.3 million (low-end of range) yields gross profit of $19.7 million. Subtracting cash operating expenses of $15.7 million ($3.9 million per quarter compared to initial fiscal 2010 guidance of $3.5 million per quarter) yields cash operating income of $4.0 million ($0.91, or nearly $1.00 per share). Net operating losses (NOLs) of $87 million should shield cash taxes for many years and, in our view, represent another under-appreciated company asset (*investors often assign limited value to NOLs if a company's ability to use them is unclear, yet our understanding is that Sonic Foundry will be able to apply NOLs).
  • Multiple scenarios are presented below - click to enlarge:
  • One caveat is that Sonic Foundry plans to add additional debt to fund rapid growth in working capital, with incremental interest expense slightly reducing expected earnings. The company had a net cash position of $1.3 million at 12/31/09, down from $2.9 million one year earlier (= burn of $1.60 million). However, if expected growth and positive free cash flow materializes, Sonic Foundry should be able to reduce debt and interest expense by repaying borrowings.
  • Applying a forward P/E multiple of 20x – 30x to $1.00 of cash earnings (rounded up from $0.91) implies a fair value of $20-$30 this summer. We're not an advocate of simply awarding high multiples, but again, please see our post re: Fortune tech picks for insight into how the Market might value SOFO once the company garners investor attention. Please note that we'll happily accommodate future Market interest by reducing our position at higher multiples.
  • Further, a reproduction analysis suggests a fair value per share range of $20 to $27 ($23.5 midpoint) today (please see our initial "Mediasite franchise" post). Recent M&A comparable transactions (e.g. Cisco/Tandberg, Logitech/LifeSize, Google/On2 Technologies) imply similar valuations would be awarded by an informed private market buyer, although non-public insights (under non-disclosure agreement) into Sonic Foundry’s forward pipeline could yield higher values.
  • Key risks to realizing fair value: delays in closing large deals, further reductions to IT budgets (especially in higher education), working capital financing needs, and potential competition. In addition, note that the stock is thinly traded with a small float and, therefore, subject to wide swings. Finally, we remind readers that forecasting is a dangerous game, especially for smaller companies such as Sonic Foundry. We could be wrong.
We look forward to an update on business trends and timing for large deals tomorrow during Sonic Foundry's annual shareholder meeting. The Mediasite Webcast begins at 10am EST.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO.

© 2010 Jeffrey Walkenhorst
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3 comments:

  1. I wish to compliment you on your work. I really enjoy the analysis you post.

    Just a literal here: the SI is 1% of SOFO float, not 10%.

    ReplyDelete
  2. thanks Maedhros and thanks for reading.

    Whoops, you're correct on the SI. Not sure what planet I was on when I made that calculation. I will correct. Thanks for pointing this out.

    Br,
    JW

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