SONIC FOUNDRY INC - Quarter Report: 2003 December (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly period ended December 31, 2003

OR

Commission File Number 1-14007

SONIC FOUNDRY, INC.

(Exact name of registrant as specified in its charter)

222 West Washington Ave, Suite 775, Madison, WI 53703

(Address of principal executive offices)

(608)443-1600

(Registrant’s telephone

number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days

Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No x

State the number of shares outstanding of each of the issuer’s common equity as of the last practicable date:

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Sonic Foundry, Inc.

Consolidated Balance Sheets

(in thousands except for share data)

See accompanying notes

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Sonic Foundry, Inc.

Statements of Operations

(in thousands except for per share data)

(Unaudited)

See accompanying notes

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Sonic Foundry, Inc.

Consolidated Statements of Cash Flows

(in thousands)

(Unaudited)

See accompanying notes

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Sonic Foundry, Inc. (the Company) is in the business of developing automated rich-media application software and systems, (our “Media Systems” business). Our current operations were formed in October 2001 when we acquired the assets and assumed certain liabilities of MediaSite, Inc. (“MediaSite”).

Until recently, we were engaged in three businesses – Media Services, Desktop Software and Media Systems. Our media services operation (“Media Services”) provided format conversion, tape duplication, film restoration and other services to the media, broadcast and entertainment industries. On May 16, 2003, the Company completed the sale of the Media Services business.

The desktop software business (“Desktop Software”) designed, developed, marketed and supported software products for digitizing, converting, editing and publishing audio, video, and/or multimedia content. On July 30, 2003, the Company completed the sale of the Desktop Software business to a subsidiary of Sony Pictures Digital.

All revenue and expenses included in the results of operations of both the Media Services business and the Desktop Software business have been presented as discontinued operations (the “Discontinued Operations”) and previously reported consolidated financial statements have been restated to reflect the discontinued operations presentation. See Note 2 – Management’s Plan and Discontinued Operations.

Interim Financial Data

The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States (“GAAP”) for complete financial statements and should be read in conjunction with the Company’s annual report filed on Form 10-K for the fiscal year ended September 30, 2003. In the opinion of management, all adjustments (consisting only of adjustments of a normal and recurring nature) considered necessary for a fair presentation of the results of operations have been included. Operating results for the three-month period ended December 31, 2003 are not necessarily indicative of the results that might be expected for the year ended September 30, 2004.

Revenue Recognition

General

Revenue is recognized when persuasive evidence of an arrangement exists, delivery occurs or services are rendered, the sales price is fixed or determinable and collectibility is reasonably assured. Revenue is deferred when undelivered products or services are essential to the functionality of delivered products, customer acceptance is uncertain, significant obligations remain, or the fair value of undelivered elements is unknown. The Company has not accepted product returns, other than for limited warranty repairs, and does not offer price protection, rebates or other offerings that occur under sales programs and accordingly, does not reduce revenue for such programs. The following policies apply to the Company’s major categories of revenue transactions.

Products

Products are considered delivered, and revenue is recognized, when title and risk of loss have been transferred to the customer. Under the terms and conditions of the sale, this occurs at the time of shipment to the customer. Product revenue currently represents sales of our MediaSite Live (“MSL”) product, excluding the revenue generated from service-related solutions, which is included in services revenue discussed below.

Services

We sell support contracts to customers of our MSL hardware, typically one year in length, and record the related revenue ratably over the contractual period. Our support contracts cover phone and electronic technical

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support availability over and above the level provided by our distributors as well as an extension of the standard hardware warranty from 90 days to one year. Hardware warranty service is performed by the manufacturer we contract with to build the units. Revenue for time and material contracts such as training fees are recognized as services are rendered. Service amounts invoiced to customers in excess of revenue recognized are recorded as deferred revenue until the revenue recognition criteria are met.

Other

Other revenue consists of software licensing of MediaSite Publisher and custom software development performed under time and materials or fixed fee arrangements. Software licensing is recorded when persuasive evidence of an arrangement exists, delivery occurs, the sales price is fixed or determinable and collectibility is reasonably assured. Custom software development includes fees recorded pursuant to long-term contracts (including research grants), using the percentage of completion method of accounting, when significant customization or modification of a product is required.

Revenue Arrangements that Include Multiple Elements

Revenue for transactions that include multiple elements such as hardware, software, training, and support agreements is allocated to each element based on its relative fair value and recognized for each element when the revenue recognition criteria have been met for such element. Fair value is generally determined based on the price charged when the element is sold separately. In the absence of fair value of a delivered element, revenue is allocated first to the fair value of the undelivered elements and the residual revenue to the delivered elements. The Company recognizes revenue for delivered elements only when all of the following criteria are satisfied: undelivered elements are not essential to the functionality of delivered elements, uncertainties regarding customer acceptance are resolved, and the fair value for all undelivered elements is known.

Shipping and Handling

Costs related to shipping and handling are included in cost of sales for all periods presented.

We perform ongoing credit evaluations of our customers’ financial condition and generally do not require collateral. We maintain allowances for potential credit losses and such losses have been within our expectations.

Cash, Cash Equivalents and Short-term investments

The company considers all highly liquid investments, generally with a maturity of three months or less, to be cash equivalents.

Inventories

Inventory consists of raw materials and supplies used in the assembly of MediaSite Live units.

Stock Based Compensation

As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company follows Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” in accounting for its stock option plans. Had the Company accounted for its stock option plans based upon the fair value at the grant date for options granted under the plan, based on the provisions of SFAS 123, the Company’s pro forma net income (loss) and pro forma net loss per share would have been as follows (for purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period):

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Pro forma information regarding net loss and net loss per share and has been determined as if the Company had accounted for its employee stock options under the minimum value method of SFAS No. 123 for option grants made prior to the Company’s initial public offering and the Black-Scholes method for grants made subsequent to such offering. With the exception of volatility (which is ignored in the case of the minimum value method), the following weighted-average assumptions were used for all periods presented: risk-free interest rates of 1.7% to 6%, dividend yields of 0%; expected common stock market price volatility factors ranging from .50 to 1.38 and a weighted-average expected life of the option of one to five years.

Per share computation

The following table sets forth the computation of basic and diluted loss per share:

Accounting Pronouncements

In November 2002, the EITF reached a consensus on Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (EITF 00-21). EITF 00-21 establishes criteria to determine whether an arrangement that contains multiple deliverables should be divided into separate units of accounting and how the arrangement consideration should be allocated among the separate units. EITF 00-21 was effective for arrangements entered into after June 30, 2003.

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46). FIN 46 requires a company to consolidate any variable interest entities for which the company has a controlling financial interest. FIN 46 also requires disclosures about the variable interest entities that the Company is not required to consolidate, but in which it has a significant variable interest. The Company adopted the consolidation requirements of FIN 46 on February 1, 2003.

The adoption of EITF 00-21 and FIN 46 had no effect on the Company’s financial position, results of operations or stockholders’ equity.

In the fall of 2002, the Company determined that operations of our Desktop Software and Media Services businesses, along with our existing cash reserves, would not provide sufficient cash flow to fund planned growth of the systems division and make remaining subordinated debt payments. In response, the Company retained an advisor to evaluate the sale of certain operating assets.

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Media Services

The Company completed the sale of assets utilized in the Media Services business on May 16, 2003 with Deluxe Media Services (“Deluxe”). The transaction included all assets utilized in the Company’s Media Services business primarily affecting business conducted from and employees in the Company’s Santa Monica California and Toronto Canada facilities. Under terms of the agreement, Deluxe acquired the Media Services business for approximately $5.6 million including cash of $4.5 million plus an estimate of $1.1 million for net working capital and assumption of certain capital leases. The Company received $5.2 million at close with the remainder due upon a final determination of actual working capital. The Company received $350 thousand of the remainder in September 2003 and settled on a final payment of $241 thousand in January 2004. The Company recorded a gain on sale of discontinued operations of $173 thousand in the first quarter of 2004 to reflect the amount that the January 2004 payment exceeded the working capital estimates. Overall, the disposition of the Media Services business resulted in a cumulative loss of $1.8 million. Details of the discontinued Media Services business are as follows (in thousands):

Desktop Software

The Company entered into an amended and restated asset purchase agreement with a subsidiary of Sony Pictures Digital, dated June 6, 2003 and effective May 2, 2003, to sell the assets of the Company’s Desktop Software business for $19 million cash and assumption of certain trade payables, accrued liabilities and capital leases associated with the Desktop Software business. The transaction was completed on July 30, 2003. The negotiated price of the transaction contemplated net working capital balances at March 31, 2003 with any difference between the values at March 31, 2003 and the date of close to be reflected as a post closing adjustment. The Company’s net working capital decreased during the period preceding close due to improved collections of customer accounts, leading to an adjustment in the purchase price of $497 thousand which was paid to Sony Pictures Digital in December 2003. The Company recorded a gain on the disposal of the Desktop Software business in the fourth fiscal quarter of 2003 of $13.9 million. Upon final settlement in December 2003, the Company recorded a $53 thousand loss. Details of the discontinued Desktop Software business are as follows (in thousands):

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The following discussion of the consolidated financial position and results of operations of the Company should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this form 10-Q and the Company’s annual report filed on form 10-K for the fiscal year ended September 30, 2003. In addition to historical information, this discussion contains forward-looking statements such as statements of the Company’s expectations, plans, objectives and beliefs. These statements use such words as “may,” “will,” “expect,” “anticipate,” “believe,” “plan,” and other similar terminology. Actual results could differ materially due to changes in the market acceptance of our products, market introduction or product development delays, our ability to effectively integrate acquired businesses, global and local business conditions, legislation and governmental regulations, competition, our ability to effectively maintain and update our product portfolio, shifts in technology, political or economic instability in local markets, and currency and exchange rate fluctuations, as well as other factors which may be identified from time to time in Sonic Foundry’s Securities and Exchange Commission filings and other public announcements.

Overview

Sonic Foundry, Inc. is in the business of developing automated rich-media application software and systems, (our “Media Systems” business). The Media Systems business was formed in October 2001, when our wholly-owned subsidiary, Sonic Foundry Systems Group, Inc. acquired the assets and assumed certain liabilities of MediaSite, Inc. (“MediaSite”). Our internally developed software code, coupled with our acquired systems technology, includes advanced publishing tools and media access technologies operating across multiple digital delivery platforms to significantly enhance a host of enterprise-based media applications. Our solutions are based on unique and, in some cases, patented technologies that enhance media communications through the extensive use of rich-media, defined as a media element that combines graphics, text, video, audio and metadata in a single data file. The core products include MediaSite Live (“MSL”) a web presentation and webcasting system and Publisher, a software product for creating accessible and searchable rich media presentations.

Our Media Services and Desktop Software businesses were sold in fiscal 2003 and reported under the caption of discontinued operations. The sale of our Media Services and Desktop Software businesses significantly affect the comparability of our results of operations from year to year. You should read the following discussion of our results of operations and financial condition in conjunction with our consolidated financial statements and related notes thereto included in this quarterly report and our Annual Report on Form 10-K.

Critical Accounting Policies

We have identified the following as critical accounting policies to our Company and have discussed the development, selection of estimates and the disclosure regarding them with the audit committee of the board of directors:

Revenue Recognition and Allowance for Doubtful Accounts

We recognize revenue for product sales and licensing of software products upon shipment, provided that collection is determined to be probable and no significant obligations remain. The Company does not offer rights of return and typically delivers products either to value added resellers based on end-user customer orders or direct to the end user. We sell post-contract support (“PCS”) contracts on our MediaSite Live units. Revenue is recorded separately from the sale of the product and recognized over the life of the support contract using vendor specific objective evidence of the value of the support services. Please refer to Note 1 of our Notes to Consolidated Financial Statements for further information on our revenue recognition policies.

The preparation of our consolidated financial statements also requires us to make estimates regarding the collectability of our accounts receivables. We specifically analyze the age of accounts receivable and historical bad

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debts, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

Impairment of long-lived assets

We assess the impairment of goodwill and capitalized software development costs on an annual basis or whenever events or changes in circumstances indicate that the fair value of these assets is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:

If we determine that the fair value of goodwill is less than its carrying value, based upon the annual test or the existence of one or more of the above indicators of impairment, we would then measure impairment based on a comparison of the implied fair value of goodwill with the carrying amount of goodwill. To the extent the carrying amount of goodwill is greater than the implied fair value of goodwill, we would record an impairment charge for the difference.

We evaluate all of our long-lived assets, including intangible assets other than goodwill, for impairment in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS 144 requires that long-lived assets and intangible assets other than goodwill be evaluated for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. Should events indicate that any of our long-lived assets are impaired; the amount of such impairment will be measured as the difference between the carrying value and the fair value of the impaired asset and recorded in earnings during the period of such impairment.

Valuation allowance for net deferred tax assets

Deferred income taxes are provided for temporary differences between financial reporting and income tax basis of assets and liabilities, and are measured using currently enacted tax rates and laws. Deferred income taxes also arise from the future benefits of net operating loss carryforwards. For the US operations, a valuation allowance equal to 100% of the net deferred tax assets has been recognized due to uncertainty regarding future realization.

Results of Continuing Operations

Revenue

Revenue from our Media Systems business include the sales of our MediaSite Live product and related customer support contracts sold separately as well as fees charged for the licensing of software products and custom software development. The primary focus is on the platforms of MediaSite Publisher^™ and MediaSite Live^™. These products are marketed to government agencies, educational institutions, and corporations who need to deploy, manage, index and distribute video content on IP-based networks. We reach our customers through reseller networks, a direct sales effort and partnerships with system Integrators.

Revenues in Q1-2004 totaled $899 compared to Q1-2003 sales of $173. Sales consisted of the following:

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Gross Margin

The significant components of Q1-2004 cost of systems include:

Operating Expenses

Selling and Marketing Expenses

Selling and marketing expenses include wages and commissions for sales, marketing, business development and technical support personnel, print advertising and various promotional expenses for our products. Timing of these costs may vary greatly depending on introduction of new products and services or entrance into new markets.

Q1-2004 compared to Q1-2003

The $179 thousand or 19% decrease from Q1-2003 to Q1-2004 resulted from:

As of December 31, 2003 we had 14 employees in Selling and Marketing. We anticipate adding 5 - 10 additional people in the upcoming quarters in order to pursue sales growth in additional regions and support a growing number of customers.

General and Administrative Expenses

General and administrative (“G&A”) expenses consist of personnel and related costs associated with the facilities, finance, legal, human resource and information technology departments, as well as other expenses not fully allocated to functional areas.

Q1-2004 compared to Q1-2003

G&A decreased $30 thousand or 4% from Q1-2003 to Q1-2004. With the exception of professional fees and insurance premiums, unallocated G&A costs remained fairly constant from period to period. Professional fees (accounting, legal, consulting and transfer/registration fees) and insurance premiums made up 52% of the Q1-2004 G&A total. Some significant differences between the periods include:

As of December 31, 2003 we had 8 full-time employees in G&A. There are no near term plans to expand these departments.

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Product Development Expenses

Product development expenses include salaries and wages of the software research and development staff and an allocation of benefits, facility and administrative expenses. Fluctuations in product development expenses correlate directly to changes in headcount.

Q1-2004 compared to Q1-2003

R&D expenses decreased $102 thousand, or 22%. Attrition and workforces reductions of the now closed Pittsburgh location accounted for all of the change. The reduction in staff reflects a decision to focus on the MediaSite Live product and offer no near term upgrades of the MediaSite Publisher product.

As of December 31, 2003 we had 12 employees in Research and Development. We anticipate growing R&D by an additional 5 – 10 people over the next year. We do not anticipate that any fiscal 2003 software development efforts will qualify for capitalization under SFAS No. 86 “Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed.”

Other Income

Other income is primarily interest income. We are currently investing in certificates of deposit and overnight investment vehicles.

Discontinued Operations

In the fall of 2002, the Company determined that operations of our Desktop Software and Media Services business would not provide sufficient cash flow along with our existing cash reserves to fund planned growth of the systems division and make remaining subordinated debt payments. In response, the Company retained an advisor to evaluate the sale of certain operating assets. On May 16, 2003, we completed the sale of the assets used in our Media Services business to Deluxe Media Services for gross proceeds of $5.6 million cash, including an estimate of net working capital, plus assumption of certain leases and other obligations. On July 30, 2003 we completed the sale of the assets of our Desktop Software business to SP Acquisition Company, for $19.0 million cash and assumption of certain trade payables, accrued liabilities and capital leases associated with the Desktop Software business. We have accounted for the sale of both businesses as discontinued operations in accordance with SFAS No. 144 “Accounting for the Impairment and Disposal of Long-Lived Assets.” Accordingly, the results of the Media Services business and the Desktop Software business for all periods presented are included in the consolidated financial statements and MD&A as discontinued operations.

Details of the discontinued Media Services business are as follows:

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Details of discontinued Desktop Software business are as follows:

Liquidity and Capital Resources

Cash used in operating activities was $1.8 million for Q1-2004 compared to $1.6 million in Q1-2003 – an increase of $231 thousand or 15%. Q1-2004 had greater outflows related to: 1) accounts payable that had accumulated prior to the Desktop Software transaction; 2) a $114 thousand increase in unearned revenue related to MediaSite Live service plans and specialized engineering work that had been billed but not completed; and 3) an increase in prepaid assets primarily related to $100 thousand of tax deposits.

Cash used in investing activities was $3.5 million in Q1-2004 compared to a use of $18 thousand in Q1-2003. The $3.5 million short-term investments in Q1-2004 are certificates of deposit maturing between June 2004 and December 2004. We anticipate additional short-term investments in the 6 to 18 month range, but will maintain the majority of our funds in cash and cash equivalents. Investing activities for the current year also included net proceeds from the final settlements from the sales of the Company’s Media Services and Desktop Software businesses.

Cash provided by financing activities was $1.3 million in Q1-2004 compared to cash provided of $182 thousand in Q1-2003. In Q1-2004 we received $1.3 million in option and warrant exercise proceeds. The majority of option and warrant holders who exercised were employees terminated in the Desktop Software transaction. In Q1-2004, we also received $10 thousand in proceeds from our Employee Stock Purchase Plan. In Q1-2003 we completed a bridge financing transaction of $1.0 million with the brother of Rimas Buinevicius, Chief Executive Officer. During Q1-2003 we also paid $838 thousand of lease and debt payments and $87 thousand on the line of credit of our Canadian operations.

We expect to fund the next 12 months of operations with funds on hand and have no plans to pursue any debt or lease arrangements at this time. In order to fund long term cash requirements and/or pursue complimentary business strategies, we may evaluate the issuance of stock to investors or strategic partners.

Recent Developments Impacting Liquidity

The Company determined in the fall of 2002 that operations of our Desktop Software and Media Services businesses, along with our existing cash reserves, would not provide sufficient cash to fund planned growth of the systems division and make remaining subordinated debt payments. In response, the Company retained an advisor to evaluate the sale of certain operating assets and in May 2003, completed the sale of the Media Services business for approximately $5.6 million cash, including an estimate of $1.1 million for net working capital. In July 2003, we completed the sale of the Desktop Software business for $19.0 million cash, certain other consideration and assumption of certain trade payables, accrued liabilities and capital leases. Proceeds of the transactions were used to retire all outstanding indebtedness including convertible subordinated notes and a bridge loan.

The Company expects the proceeds of the asset sale transactions noted above to provide sufficient liquidity to fund operations for at least the next twelve months.

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Derivative Financial Instruments

The Company is not party to any derivative financial instruments or other financial instruments for which the fair value disclosure would be required under SFAS No. 107, Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments. The Company’s cash equivalents consist of overnight investments in money market funds that are carried at fair value. Accordingly, we believe that the market risk of such investments is minimal.

Interest Rate Risk

The Company’s cash equivalents are subject to interest rate fluctuations, however, we believe this risk is immaterial due to the short-term nature of these investments.

Foreign Currency Exchange Rate Risk

All international sales of our products are denominated in US dollars.

Evaluation of Disclosure Controls and Procedures

Based on evaluations at December 31, 2003, our principal executive officer and principal financial officer, with the participation of our management team, have concluded that our disclosure controls and procedures (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Securities Exchange Act) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC.

Changes in Internal Controls

There were no significant changes in our internal controls or in other factors that could significantly affect these internal controls subsequent to the date of their most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II OTHER INFORMATION

On December 29, 2003, Registrant filed a report dated December 18, 2003 on Item 9 of Form 8-K with respect to fiscal 2003 financial results. No financial statements were filed with this report.

ITEM 6(a)

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Registrant will furnish upon request to the Securities and Exchange Commission a copy of all exhibits, annexes and schedules attached to each contract referenced in item 10.

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SIGNATURES

Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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