SONIC FOUNDRY INC - Quarter Report: 2005 June (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 June 30, 2005

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)

(Unaudited)

See accompanying notes

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Sonic Foundry, Inc

Statements of Operations

(in thousands, except for 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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Notes to Consolidated Financial Statements

(Unaudited)

1. Basis of Presentation and Significant Accounting Policies

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

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, 2004. 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 and nine month periods ended June 30, 2005 are not necessarily indicative of the results that might be expected for the year ending September 30, 2005.

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 does not offer customers the right to return product, other than for warranty repairs, and does not offer price protection, rebates and 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 product, excluding the revenue generated from customer support services, which is included in customer support fees discussed below, and Mediasite related products such as server software revenue.

Customer Support Fees

We sell support contracts to our Mediasite customers, typically one year in length and record the related revenue ratably over the contractual period. We also sell installation and training services and recognize revenue for those services when performed. Our support contracts cover phone and electronic technical support availability over and above the level provided by our distributors, software upgrades, advance replacement and an extension of the standard hardware warranty from 90 days to one year. The manufacturer we contract with to build the units performs hardware warranty service. 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 our Publisher product, custom software development performed under time and materials or fixed fee arrangements and amounts charged for shipping and handling. 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

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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. Shipping and handling is recorded at the time of shipment to the customer.

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 is included in cost of sales for all periods presented.

Credit Evaluation

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 and Cash Equivalents

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 units. Inventory of completed Mediasite units and spare parts are carried at the lower of cost or market, with cost determined on a first-in, first-out basis.

Inventory consists of the following (in thousands):

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Stock Based Compensation

The Company follows the intrinsic value method 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, the Company’s pro forma net 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):

Pro forma information regarding net loss and net loss per share 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 2.59 and a weighted-average expected life of the option of one to five years.

Per share computation

The numerator for the calculation of basic and diluted earnings per share is net loss. The following table sets forth the computation of basic and diluted loss per share:

Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued revised Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment – an Amendment of FASB Statement Nos. 123 and 95”. SFAS 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services or incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments, focusing primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions) and recognize the cost over the period during which an employee is required to provide service in exchange for the award. The Company is required to adopt SFAS No. 123(R) in fiscal 2006 beginning October 1, 2005. The Company is evaluating the impact of SFAS No. 123(R) and expects that it will record substantial non-cash compensation expenses. The adoption of SFAS No. 123(R) is not expected to have a significant effect on the Company’s financial condition or cash flows but is expected to have a significant adverse effect on the reporting of its results of operations.

In November 2004, the FASB issued SFAS Statement No. 151, “Inventory Costs – an amendment of ARB No. 43” (“SFAS 151”), which is the result of its efforts to converge U.S. accounting standards for inventories with

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International Accounting Standards. SFAS No. 151 requires idle facility expenses, freight, handling costs, and wasted material (spoilage) costs to be recognized as current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We are evaluating the impact of this standard on our financial statements. The Company does not expect that the adoption of SFAS 151 will have an impact on the company’s financial position, results of operations or cash flows.

2. Related Party Transactions

During the three and nine month periods ended June 30, 2005, the Company recorded Mediasite product and customer support revenue related to $92 thousand and $468 thousand of billings to MSKK, a Japanese reseller in which the Company has a 23% equity interest.

3. Purchase Commitments

The Company enters into unconditional purchase commitments on a regular basis for the supply of Mediasite product. The Company has an obligation to purchase a remaining $919 thousand over the next three fiscal quarters, which is not recorded on the Company’s Balance Sheet. There were no obligations under such commitments as of June 30, 2004.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Risks and Uncertainties

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, 2004. 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 from expectations due to changes in the market acceptance of our products, competition, market introduction or product development delays; all of which would impact our strategy to develop a network of inside regional sales managers and distribution partners that target customer opportunities for multi-unit and repeat purchases. If the Company does not achieve multi-unit and repeat purchases our business will be harmed.

Other factors that may impact actual results include: 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 issues 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 “Rich Media” business). The Rich Media 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.. 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 and Publisher. Mediasite is a system that can record presentations and stream them live over the Internet or archive them for on-demand playback. Publisher is a software product for creating accessible and searchable rich media presentations.

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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, if 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 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 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.

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Results of Continuing Operations

Revenue

Revenues from our business include the sales of our Mediasite product and related customer support contracts sold separately as well as fees charged for the licensing of software products and custom software development. Our products are marketed to educational institutions, corporations and government agencies that need to deploy, manage, index and distribute video content on Internet-based networks. We reach both our domestic and international markets through reseller networks, a direct sales effort and partnerships with system integrators.

Q3-2005 compared to Q3-2004

Revenues in Q3-2005 totaled $2.18 million compared to Q3-2004 sales of $1.15 million. Revenues consisted of the following:

Product revenue from the sale of Mediasite capture units increased almost $900 thousand from $959 thousand in 2004 to $1.86 million in Q3-2005. The increase is due to many factors including increases in internal and external sales and marketing efforts, demand generated from prior sales to high profile reference accounts, repeat purchases from existing customers, the addition of server software to the mix, the release of new versions of Mediasite and product enhancements.

YTD-2005 (nine months) compared to YTD-2004 (nine months)

Revenues for YTD-2005 totaled $5.83 million compared to YTD-2004 sales of $2.99 million. Revenues included the following:

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Gross Margin

Total gross margins for Q3-2005 were $1.40 million or 64% compared to Q3-2004 of $711 thousand or 62%. High margin customer support revenue, and licensing of server software applications accounted for the majority of the increase in the gross margin rate over 2004 levels. The significant components of cost of revenue 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, trade shows and various promotional expenses for our products. Timing of these costs may vary greatly depending on introduction of new products and services, entrance into new markets or participation in major tradeshows.

Q3-2005 compared to Q3-2004

The $239 thousand or 20% increase from Q3-2004 to Q3-2005 resulted from numerous items. Significant differences included:

YTD-2005 compared to YTD-2004

The $1.06 million or 39% increase from YTD-2004 to YTD-2005 resulted from increases in many of the same items mentioned in the quarter discussion above. YTD increases in the major categories include:

As of June 30, 2005 we had 27 employees in Selling and Marketing. Marketing costs were unusually high in Q3-2005 due to expenses incurred for a large tradeshow, we anticipate marketing costs to decrease in the upcoming quarter, offset by increased salaries and commissions of sales personnel related to anticipated growth in revenues.

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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.

Q3-2005 compared to Q3-2004

G&A decreased $88 thousand or 12% from Q3-2004 to Q3-2005. Components of the variance are as follows:

YTD-2005 compared to YTD-2004

G&A increased $173 thousand or 8% from YTD-2004 to YTD-2005. Lease costs and depreciation associated with expanded facilities attributed $115 thousand of the increase, and salaries and wages increased $216 thousand over last year. These increases were partially offset by a decrease in professional fees, annual report costs and utilization of certain retirement and other credits, totaling $144 thousand.

As of June 30, 2005 we had 9 full-time employees in G&A. There are no near term plans to expand these departments. We expect G&A expenses to remain consistent for the remainder of the year.

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.

Q3-2005 compared to Q3-2004

Q3-2005 R&D expenses increased $38 thousand, or 9% from Q3-2004. The increase is due primarily to additional engineering development to accelerate release of enhancements to our existing Mediasite product as well as development of channel specific add-on components and future versions of the Mediasite product. In Q3-2005, 79% of R&D costs related to salaries and benefits.

YTD-2005 compared to YTD-2004

YTD-2005 R&D expenses increased $191 thousand, or 16% from YTD-2004. As mentioned in the quarter discussion above, salaries, commissions and benefits were the primary reason for the increase, accounting for $143 thousand of the increase over the prior year. Additional contributors to the increase included facilities related expenses and intellectual property related legal fees. In YTD-2005, 78% of R&D costs related to salaries and benefits.

As of June 30, 2005 we had 16 employees in Research and Development. We do not anticipate significant additional growth in R&D headcount in fiscal 2005. We do not anticipate that any fiscal 2005 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.

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Gain on disposal of discontinued operations

The Company recorded a net gain of $120 thousand in Q1-2004 relating to final adjustments of the sales price of the Desktop Software and Media Services businesses, sold in 2003.

Liquidity and Capital Resources

Cash used in operating activities was $3.26 million for YTD-2005 compared to $4.69 million in YTD-2004. Significant YTD-2005 outflows included: 1) a $615 thousand increase in accounts receivable; and 2) a $199 thousand decrease in accounts payable and accrued liabilities: In YTD-2005 we also had a $272 thousand increase in unearned revenue related to Mediasite customer support agreements; and a decrease in inventory of $106 thousand. In YTD-2004 we had significant cash outflows from the payment of accounts payable and accrued liabilities that had accumulated prior to the sale of the Desktop Software business.

Cash used in investing activities was $284 thousand in YTD-2005 and $4.79 million in YTD-2004. The prior year included $4.55 million of outflows to purchase short-term investments that matured between September 2004 and June 2005. Investing activities for the prior 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 $473 thousand for YTD-2005 compared to $1.45 million in YTD-2004. The amount received in the current year relates to option and warrant exercise proceeds. Nearly the entire amount received in the prior year related to option and warrant exercise proceeds from employees terminated in the Desktop Software transaction.

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. To fund long-term cash requirements and/or pursue complementary business strategies, we may evaluate the issuance of stock to investors or strategic partners.

The Company enters into unconditional purchase commitments on a regular basis for the supply of Mediasite product. The Company has an obligation to purchase a remaining $919 thousand over the next three fiscal quarters, which is not recorded on the Company’s Balance Sheet. There were no obligations under such commitments as of June 30, 2004.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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.

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Item 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Based on evaluations at June 30, 2005, 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

During the period covered by this quarterly report on Form 10-Q, the Company has not made any changes to its internal control over financial reporting (as referred to in Paragraph 4(c) of the Certifications of the Company’s principal executive officer and principal financial officer included as exhibits to this report) that have materially affected, or is reasonably likely to affect the Company’s internal control over financial reporting.

PART II OTHER INFORMATION

Item 6. EXHIBITS

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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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