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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the Quarterly period ended December 31, 2004



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



Commission File Number 1-14007



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SONIC FOUNDRY, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|MARYLAND                                                       |  | 39-1783372                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



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

(Address of principal executive offices)



(608)443-1600

(Registrants telephone number including area code)



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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:



|                              |  |                             
|----------------------------- |  | ----------------------------
|Class                         |  | Outstanding February 1, 2005
|Common Stock, $0.01 par value |  | 30,148,233                  



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##### Table of Contents

TABLE OF CONTENTS



|        |  |                                                                                                   |  |         
|------- |  | ------------------------------------------------------------------------------------------------- |  | --------
|        |  |                                                                                                   |  | PAGE NO.
|PART I  |  | FINANCIAL INFORMATION                                                                             |  |         
|        |  |                                                                                                  
|Item 1. |  | Consolidated Financial Statements                                                                 |  |         
|        |  |                                                                                                  
|        |  | Consolidated Balance Sheets  December 31, 2004 (Unaudited) and September 30, 2004                |  | 3       
|        |  |                                                                                                  
|        |  | Consolidated Statements of Operations (Unaudited)  Three months ended December 31, 2004 and 2003 |  | 4       
|        |  |                                                                                                  
|        |  | Consolidated Statements of Cash Flows (Unaudited)  Three months ended December 31, 2004 and 2003 |  | 5       
|        |  |                                                                                                  
|        |  | Notes to Consolidated Financial Statements (Unaudited)                                            |  | 6       
|        |  |                                                                                                  
|Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations             |  | 9       
|        |  |                                                                                                  
|Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk                                        |  | 13      
|        |  |                                                                                                  
|Item 4. |  | Controls and Procedures                                                                           |  | 14      
|        |  |                                                                                                  
|PART II |  | OTHER INFORMATION                                                                                 |  |         
|        |  |                                                                                                  
|Item 6. |  | Exhibits and Reports on Form 8-K                                                                  |  | 15      



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##### Table of Contents

Sonic Foundry, Inc.

Consolidated Balance Sheets

(in thousands except for share data)



|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                                                  |  | December 31,2004 |          |   | September 30,2004 |  
|                                                                                                                                                                                                  |  | (unaudited)      |          |   |                   |  
|Assets                                                                                                                                                                                            |  |                  |          |   |                   |   |          |  
|Current assets:                                                                                                                                                                                   |  |                  |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                                         |  | $                | 6,365    |   |                   | $ | 7,583    |  
|Accounts receivable, net of allowances of $98 each period                                                                                                                                         |  |                  | 1,303    |   |                   |   | 1,345    |  
|Accounts receivable, other                                                                                                                                                                        |  |                  | 15       |   |                   |   | 18       |  
|Inventories                                                                                                                                                                                       |  |                  | 391      |   |                   |   | 371      |  
|Prepaid expenses and other current assets                                                                                                                                                         |  |                  | 211      |   |                   |   | 281      |  
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Total current assets                                                                                                                                                                              |  |                  | 8,285    |   |                   |   | 9,598    |  
|Property and equipment:                                                                                                                                                                           |  |                  |          |   |                   |   |          |  
|Leasehold improvements                                                                                                                                                                            |  |                  | 185      |   |                   |   | 185      |  
|Computer equipment                                                                                                                                                                                |  |                  | 1,031    |   |                   |   | 1,010    |  
|Furniture and fixtures                                                                                                                                                                            |  |                  | 177      |   |                   |   | 177      |  
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Total property and equipment                                                                                                                                                                      |  |                  | 1,393    |   |                   |   | 1,372    |  
|Less accumulated depreciation                                                                                                                                                                     |  |                  | 702      |   |                   |   | 627      |  
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Net property and equipment                                                                                                                                                                        |  |                  | 691      |   |                   |   | 745      |  
|Other assets:                                                                                                                                                                                     |  |                  |          |   |                   |   |          |  
|Goodwill and other intangibles, net                                                                                                                                                               |  |                  | 7,663    |   |                   |   | 7,676    |  
|Capitalized software development costs, net of amortization of $857 and $788                                                                                                                      |  |                  | 543      |   |                   |   | 612      |  
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Total other assets                                                                                                                                                                                |  |                  | 8,206    |   |                   |   | 8,288    |  
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Total assets                                                                                                                                                                                      |  | $                | 17,182   |   |                   | $ | 18,631   |  
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Liabilities and stockholders equity                                                                                                                                                              |  |                  |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                                                              |  |                  |          |   |                   |   |          |  
|Accounts payable                                                                                                                                                                                  |  | $                | 797      |   |                   | $ | 879      |  
|Accrued liabilities                                                                                                                                                                               |  |                  | 363      |   |                   |   | 686      |  
|Unearned revenue                                                                                                                                                                                  |  |                  | 467      |   |                   |   | 473      |  
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                                         |  |                  | 1,627    |   |                   |   | 2,038    |  
|                                                                                                                                                                                                  |  |                 
|Other liabilities                                                                                                                                                                                 |  |                  | 26       |   |                   |   | 27       |  
|                                                                                                                                                                                                  |  |                 
|Stockholders equity:                                                                                                                                                                             |  |                  |          |   |                   |   |          |  
|Preferred stock, $.01 par value, authorized 5,000,000 shares; none issued and outstanding                                                                                                         |  |                  |         |   |                   |   |         |  
|5% preferred stock, Series B, voting, cumulative, convertible, $.01 par value (liquidation preference at par), authorized 10,000,000 shares,
none issued and outstanding                          |  |                  |         |   |                   |   |         |  
|Common stock, $.01 par value, authorized 100,000,000 shares; 30,218,483 and 29,782,269 issued and 30,148,233 and 29,712,019 outstanding at
December 31, 2004 and September 30, 2004, respectively |  |                  | 302      |   |                   |   | 298      |  
|Additional paid-in capital                                                                                                                                                                        |  |                  | 169,729  |   |                   |   | 169,383  |  
|Accumulated deficit                                                                                                                                                                               |  |                  | (154,308 | ) |                   |   | (152,908 | )
|Receivable for common stock issued                                                                                                                                                                |  |                  | (26      | ) |                   |   | (39      | )
|Treasury stock, at cost, 70,250 shares                                                                                                                                                            |  |                  | (168     | ) |                   |   | (168     | )
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                                                        |  |                  | 15,529   |   |                   |   | 16,566   |  
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                                                        |  | $                | 17,182   |   |                   | $ | 18,631   |  
|                                                                                                                                                                                                  |  |                  |          |   |                   |   |          |  



See accompanying notes



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Sonic Foundry, Inc.

Statements of Operations

(in thousands except for per share data)

(Unaudited)



|                                            |  |                                 |        |   |      |   |        |  
|------------------------------------------- |  | ------------------------------- | ------ | - | ---- | - | ------ | -
|                                            |  | Three Months Ended December 31, |       
|                                            |  | 2004                            |        |   | 2003 |  
|Continuing Operations                       |  |                                 |        |   |      |   |        |  
|Revenue:                                    |  |                                 |        |   |      |   |        |  
|Product sales                               |  | $                               | 1,339  |   |      | $ | 603    |  
|Customer support fees                       |  |                                 | 189    |   |      |   | 67     |  
|Other                                       |  |                                 | 63     |   |      |   | 229    |  
|                                            |  |                                 |        |   |      |   |        |  
|Total revenue                               |  |                                 | 1,591  |   |      |   | 899    |  
|Cost of revenue                             |  |                                 | 536    |   |      |   | 324    |  
|                                            |  |                                 |        |   |      |   |        |  
|Gross margin                                |  |                                 | 1,055  |   |      |   | 575    |  
|                                            |  |                                
|Operating expenses:                         |  |                                 |        |   |      |   |        |  
|Selling and marketing expenses              |  |                                 | 1,231  |   |      |   | 748    |  
|General and administrative expenses         |  |                                 | 815    |   |      |   | 681    |  
|Product development expenses                |  |                                 | 455    |   |      |   | 368    |  
|                                            |  |                                 |        |   |      |   |        |  
|Total operating expense                     |  |                                 | 2,501  |   |      |   | 1,797  |  
|                                            |  |                                 |        |   |      |   |        |  
|Loss from operations                        |  |                                 | (1,446 | ) |      |   | (1,222 | )
|                                            |  |                                
|Other income, net                           |  |                                 | 46     |   |      |   | 34     |  
|                                            |  |                                 |        |   |      |   |        |  
|Loss from continuing operations             |  |                                 | (1,400 | ) |      |   | (1,188 | )
|                                            |  |                                
|Gain on disposal of discontinued operations |  |                                 |       |   |      |   | 120    |  
|                                            |  |                                 |        |   |      |   |        |  
|Net loss                                    |  | $                               | (1,400 | ) |      | $ | (1,068 | )
|                                            |  |                                 |        |   |      |   |        |  
|Net loss per common share:                  |  |                                 |        |   |      |   |        |  
| basic and diluted                         |  | $                               | (0.05  | ) |      | $ | (0.04  | )
|                                            |  |                                 |        |   |      |   |        |  



See accompanying notes



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Sonic Foundry, Inc.

Consolidated Statements of Cash Flows

(in thousands)

(Unaudited)



|                                                                             |  |                                 |        |   |      |   |        |  
|---------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                             |  | Three months ended December 31, |       
|                                                                             |  | 2004                            |        |   | 2003 |  
|Operating activities                                                         |  |                                 |        |   |      |   |        |  
|Net loss                                                                     |  | $                               | (1,400 | ) |      | $ | (1,068 | )
|Adjustments to reconcile net loss to net cash used in operating activities:  |  |                                 |        |   |      |   |        |  
|Gain on sale of discontinued operations                                      |  |                                 |       |   |      |   | (120   | )
|Amortization of intangible assets and capitalized software development costs |  |                                 | 82     |   |      |   | 82     |  
|Depreciation and amortization of property and equipment                      |  |                                 | 74     |   |      |   | 52     |  
|Noncash compensation charges for stock warrants and options                  |  |                                 | 150    |   |      |   | 59     |  
|Changes in operating assets and liabilities:                                 |  |                                 |        |   |      |   |        |  
|Accounts receivable                                                          |  |                                 | 42     |   |      |   | 70     |  
|Accounts receivable, other                                                   |  |                                 | 3      |   |      |   | (110   | )
|Inventories                                                                  |  |                                 | (20    | ) |      |   | (7     | )
|Prepaid expenses and other assets                                            |  |                                 | 48     |   |      |   | (130   | )
|Accounts payable, accrued liabilities and deferred rent                      |  |                                 | (405   | ) |      |   | (746   | )
|Unearned revenue                                                             |  |                                 | (6     | ) |      |   | 114    |  
|                                                                             |  |                                 |        |   |      |   |        |  
|Total adjustments                                                            |  |                                 | (33    | ) |      |   | (736   | )
|                                                                             |  |                                 |        |   |      |   |        |  
|Net cash used in operating activities                                        |  |                                 | (1,432 | ) |      |   | (1,804 | )
|                                                                             |  |                                
|Investing activities                                                         |  |                                 |        |   |      |   |        |  
|Purchase of short-term investments                                           |  |                                 |       |   |      |   | (3,552 | )
|Proceeds from sale of discontinued operations, net                           |  |                                 |       |   |      |   | 120    |  
|Purchases of property and equipment                                          |  |                                 | (21    | ) |      |   | (61    | )
|                                                                             |  |                                 |        |   |      |   |        |  
|Net cash used in investing activities                                        |  |                                 | (21    | ) |      |   | (3,493 | )
|                                                                             |  |                                
|Financing activities                                                         |  |                                 |        |   |      |   |        |  
|Proceeds from issuance of common stock, net of issuance costs                |  |                                 | 235    |   |      |   | 1,273  |  
|Payments on long-term debt and capital leases                                |  |                                 |       |   |      |   | (20    | )
|                                                                             |  |                                 |        |   |      |   |        |  
|Net cash provided by financing activities                                    |  |                                 | 235    |   |      |   | 1,253  |  
|                                                                             |  |                                 |        |   |      |   |        |  
|Net decrease in cash                                                         |  |                                 | (1,218 | ) |      |   | (4,044 | )
|Cash and cash equivalents at beginning of period                             |  |                                 | 7,583  |   |      |   | 12,623 |  
|                                                                             |  |                                 |        |   |      |   |        |  
|Cash and cash equivalents at end of period                                   |  | $                               | 6,365  |   |      | $ | 8,579  |  
|                                                                             |  |                                 |        |   |      |   |        |  
|Supplemental cash flow information:                                          |  |                                 |        |   |      |   |        |  
|Income taxes refunded (paid)                                                 |  |                                 |       |   |      |   | (100   | )



See accompanying notes



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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. The Mediasite assets included a 33% equity interest in a Japanese entity, Mediasite KK (MSKK), formed to distribute Mediasite products in Japan. Since the
acquisition we have fully reserved against the value of our equity interest in MSKK.



Until late fiscal 2003, we were engaged in three businesses  Media Services, Desktop Software and Rich Media. Media Services provided format conversion, tape duplication, film restoration and other services to
the media, broadcast and entertainment industries. The desktop software business (Desktop Software) designed, developed, marketed and supported software products for digitizing, converting, editing and publishing audio and video content
including products such as Sound Forge, ACID and Vegas. On May 16, 2003, the Company completed the sale of the Media Services business to Deluxe Media Services and on July 30, 2003, the Company completed the sale of the Desktop Software business to
a subsidiary of Sony Pictures Digital.



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-month period ended December 31, 2004 are not necessarily indicative of the results that might be expected for the year ended 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.



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. 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.
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.



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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 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, 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 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):



|                           |  |          |     |         |   |    
|-------------------------- |  | -------- | --- | ------- | - | ---
|                           |  | 12/31/04 |     | 9/30/04
|Raw materials and supplies |  | $        | 10  |         | $ | 10 
|Work in process            |  |          | 61  |         |   | 72 
|Finished goods             |  |          | 320 |         |   | 289
|                           |  |          |     |         |   |    
|                           |  | $        | 391 |         | $ | 371
|                           |  |          |     |         |   |    



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 loss



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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):



|                                                                               |  |                                 |        |   |      |   |        |  
|------------------------------------------------------------------------------ |  | ------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                               |  | Three months ended December 31, |       
|(in thousands)                                                                 |  | 2004                            |        |   | 2003 |  
|Net loss as reported                                                           |  | $                               | (1,400 | ) |      | $ | (1,068 | )
|Less stock-based compensation using fair value method                          |  |                                 | (147   | ) |      |   | (22    | )
|Less impact of discounted employee stock purchase plan using fair value method |  |                                 |       |   |      |   | (4     | )
|                                                                               |  |                                 |        |   |      |   |        |  
|Pro forma net loss                                                             |  | $                               | (1,547 | ) |      | $ | (1,094 | )
|                                                                               |  |                                 |        |   |      |   |        |  
|Pro forma net loss per share  basic and diluted                               |  | $                               | (0.05  | ) |      | $ | (0.04  | )
|                                                                               |  |                                 |        |   |      |   |        |  



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 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:



|                                                                                                                                          |  |                                 |  |           
|----------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- |  | ----------
|                                                                                                                                          |  | Three months ended December 31,
|                                                                                                                                          |  | 2004                            |  | 2003      
|Denominator                                                                                                                               |  |                                 |  |           
|Denominator for basic and diluted loss per share  weighted average common shares                                                         |  | 29,966,335                      |  | 29,192,146
|                                                                                                                                          |  |                                
|Securities outstanding during each year, but not included in the computation of diluted earnings per share because they are
antidilutive: |  |                                 |  |           
|Options and warrants                                                                                                                      |  | 6,434,384                       |  | 6,637,452 



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 the quarter beginning July 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.



The Company does not
expect that the adoption of other recent accounting pronouncements will have a material impact on its financial statements.



2. Related Party Transactions



During the three month period ended December 31, 2004, the Company recorded Mediasite product and customer support revenue related to $99 thousand of
billings to MSKK, a Japanese reseller in which the Company has a 33% equity interest.



3. Purchase Commitments



The Company entered
into unconditional purchase commitments during the quarter ended December 2004 for supply of Mediasite capture product totaling $1.5 million. Obligations to purchase $1.0 million over the next two fiscal quarters remain. This commitment is not
recorded on the Companys balance sheet. There are no obligations under this commitment past September 30, 2005 and no purchase commitments as of December 31, 2003.



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,



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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.



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;
| | - |  | --------------------------------------------------------



| |  |  | Impairment of long-lived assets; and
| | - |  | ------------------------------------



| |  |  | Valuation allowance for net deferred tax assets.
| | - |  | ------------------------------------------------



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 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:



| |  |  | poor economic performance relative to historical or projected future operating results;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | significant negative industry, economic or company specific trends;
| | - |  | -------------------------------------------------------------------



| |  |  | changes in the manner of our use of the assets or the plans for our business; and
| | - |  | ---------------------------------------------------------------------------------



| |  |  | loss of key personnel
| | - |  | ---------------------



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.



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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



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.



Revenues in Q1-2005 totaled $1.6 million compared to Q1-2004 sales of $899 thousand. Sales
consisted of the following:



| |  |  | Product revenue from sale of Mediasite capture units increased from $603 thousand in Q1-2004 to $1.3 million in Q1-2005 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, server software license fees and product enhancements.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                               |  |          |  |         
|---------------------------------------------- |  | -------- |  | --------
|                                               |  | Q1-2005  |  | Q1-2004 
|Units sold                                     |  | 92       |  | 44      
|Mobile to rack ratio                           |  | 0.9 to 1 |  | 1.5 to 1
|Average sales price, excluding support (000s) |  | $14.5    |  | $13.7   
|Mediasite gross margins, excluding support     |  | 68%      |  | 62%     



| |  |  | Customer support revenue represents the portion of fees charged for Mediasite SmartServe service contracts amortized over the length of the contract, typically 12 months. Customer
support revenue increased from $67 thousand in Q1-2004 to $189 thousand in Q1-2005, due primarily to increased sales of new Mediasite capture units and renewals of support contracts entered into in the prior year. At December 31, 2004 $467 thousand
of unrecognized support revenues remained in unearned revenues, of which we expect to realize as revenue in Q2-2005 consistent with was recognized in Q1-2005.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Other revenue relates to freight charges billed separately to our customers, software licensing fees for our Publisher product and certain custom software engineering projects.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In 2003 we recorded Publisher license revenues of $179 thousand from a system integrator selling to a unit of the Federal Government.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Other revenues also include revenue pursuant to a $496 thousand grant awarded by the Department of Justice (DOJ) in October 2003. DOJ revenues were constant at
approximately $50 thousand during both periods. The current phase of the project involves research and development activities in law enforcement and is expected to conclude with the recognition of the remaining $198 thousand available under the
grant and delivery of a prototype in fiscal 2005. We expect to request additional funds to further advance the technology in 2005, although there is no assurance our request will be granted.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Gross Margin



Total gross margins for Q1-2005 were $1.1 million or 66% compared to Q1-2004 of $575 thousand or 64%. The significant components of cost of
revenue include:



| |  |  | Material and freight costs for the Mediasite capture units. Costs for Q1-2005 Mediasite material and other costs amounted to $453 thousand and resulted in Mediasite gross margins
 including support revenue  of 71% compared to $232 thousand and resulting gross margins of 66% in Q1-2004. The gross margin on
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Mediasite sales varies with product mix; our rack units typically carry a higher margin than our mobile
units. Mediasite customer support revenues, server and Publisher license fees and DOJ grant revenue do not carry a cost over and above limited royalty fees discussed below and staff cost included in operating expenses - significantly enhancing
Mediasite product margins. We expect margins for Fiscal 2005 to range between 60% and 70%.



| |  |  | Amortization of Mediasite acquisition amounts assigned to purchased technology and other identified intangibles effect both periods at approximately $83 thousand per quarter and
will continue over the next 2 years for the identified intangibles of the Mediasite purchase.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Royalty fees on Publisher revenues were $9 thousand in Q1-2004 while no fees were incurred in 2005.
| | - |  | ---------------------------------------------------------------------------------------------------



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.



Q1-2005 compared to Q1-2004



The $483 thousand or 65% increase from Q1-2004 to Q1-2005 resulted from:



| |  |  | Q1-2005 salary, commissions, bonuses and benefits exceeded Q1-2004 by $336 thousand due to the growth in sales staff and revenues.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | Q1-2005 travel, supplies, postage, meeting and allocated expenses were up as a result of increase in staff.
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | Q1-2005 tradeshow, advertising, market research and public relations expenses were up $103 thousand from Q1 2004.
| | - |  | -----------------------------------------------------------------------------------------------------------------



As of December 31, 2004 we had 27 employees in Selling and Marketing. We anticipate modest
growth in selling and marketing headcount in 2005.



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.



Q1-2005 compared to Q1-2004



G&A increased $134 thousand or 20% from Q1-2004 to Q1-2005. Professional
fees (accounting, legal, consulting and transfer/registration fees) and insurance premiums made up 44% of the Q1-2005 G&A total. Some significant differences between the periods include:



| |  |  | Personnel related costs increased $119 thousand over Q1-2004 due to a number of factors including non-cash stock compensation associated with the separation of an employee, annual
wage and incentive increases and increased cost of benefits.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Facility costs including lease expense on our corporate headquarters and insurance increased $42 thousand due to in part to increased square footage under lease in June 2004.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Professional fees decreased $26 thousand from the prior year due to reduced cash and non-cash consulting costs.
| | - |  | ---------------------------------------------------------------------------------------------------------------



As of December 31, 2004 we had 8 full-time employees in G&A. We do not anticipate
additional growth in G&A headcount in fiscal 2005.



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.



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Q1-2005 compared to Q1-2004



R&D expenses increased $87 thousand, or 24%. Increase in expenses is primarily due to increase in staff from 10 in
Q1-2004 to 12 in Q1-2005.



As of December 31, 2004 we had 12
employees in Research and Development. We do not anticipate 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.



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 $1.4 million for Q1-2005 compared
to $1.8 million in Q1-2004  a decrease of $372 thousand or 21%. The decrease in Q1-2005 outflows compared to Q1-2004 outflows related to an increase in net loss, offset primarily by reduced cash requirements in various working capital
components including accounts receivable, prepaid and other assets, accounts payable, accrued liabilities and deferred rent.



Cash used in investing activities was $21 thousand in Q1-2005 compared to a use of $3.5 million in Q1-2004. The $3.5 million short-term investments in
Q1-2004 were certificates of deposit maturing between June 2004 and December 2004. Investing activities for 2004 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 $235
thousand in Q1-2005 compared to cash provided of $1.3 million in Q1-2004. In Q1-2004 we received $1.3 million in option and warrant exercise proceeds compared to $235 thousand in Q1-2005. The majority of option and warrant holders who exercised in
Q1-2004 were employees terminated in the Desktop Software transaction. In Q1-2004, we also received $10 thousand in proceeds from our Employee Stock Purchase Plan.



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.



The Company entered into unconditional purchase commitments during the
quarter ended December 2004 for supply of Mediasite capture product totaling $1.5 million. Obligations to purchase $1.0 million over the next two fiscal quarters remain. This commitment is not recorded on the Companys balance sheet. There are
no obligations under this commitment past September 30, 2005 and no purchase commitments as of December 31, 2003.



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



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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.



ITEM 4. CONTROLS AND PROCEDURES



Evaluation of
Disclosure Controls and Procedures



Based on evaluations
at December 31, 2004, 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 are reasonably likely to affect the Companys internal control over financial reporting.



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PART II OTHER INFORMATION



ITEM 6. EXHIBITS



|       |  |                                                                                                                                                                                                                                                                                                                                                                 
|------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NUMBER |  | DESCRIPTION                                                                                                                                                                                                                                                                                                                                                     
|3.1    |  | Amended and Restated Articles of Incorporation of the Registrant, filed as Exhibit No. 3.1 to the registration statement on amendment No. 2 to Form SB-2 dated April 3, 1998 (Reg. No.
333-46005) (the Registration Statement), and hereby incorporated by reference.                                                                                         
|       | 
|3.2    |  | Amended and Restated By-Laws of the Registrant, filed as Exhibit No. 3.2 to the Registration Statement, and hereby incorporated by reference.                                                                                                                                                                                                                   
|       | 
|10.1*  |  | Registrants 1995 Stock Option Plan, as amended, filed as Exhibit No. 4.1 to the Registration Statement on Form S-8 on September 8, 2000, and hereby incorporated by
reference.                                                                                                                                                                                 
|       | 
|10.2*  |  | Registrants Non-Employee Directors Stock Option Plan, filed as Exhibit No. 10.2 to the Registration Statement, and hereby incorporated by reference.                                                                                                                                                                                                          
|       | 
|10.3*  |  | Employment Agreement between Registrant and Rimas Buinevicius dated as of January 1, 2001, filed as Exhibit 10.4 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2001, and
hereby incorporated by reference.                                                                                                                               
|       | 
|10.4*  |  | Employment Agreement between Registrant and Monty R. Schmidt dated as of January 1, 2001, filed as Exhibit 10.5 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2001, and
hereby incorporated by reference.                                                                                                                                
|       | 
|10.5   |  | Commercial Lease between Ewart Associates, L.P. and Sonic Foundry Systems Group, Inc. (now known as Sonic Foundry Media Systems, Inc.), regarding 925 Liberty Avenue, Pittsburgh, PA 15222,
dated November 30, 2001, filed as Exhibit No. 10.23 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2002, and hereby incorporated by reference.
|       | 
|10.6*  |  | Registrants Amended 1999 Non-Qualified Plan, filed as Exhibit 4.1 to Form S-8 on December 21, 2001, and hereby incorporated by reference.                                                                                                                                                                                                                      
|       | 
|10.7   |  | Amended and Restated License Agreement effective October 15, 2001 between Carnegie Mellon University and Mediasite, Inc. filed as Exhibit No. 10.31 to the Quarterly Report on Form 10-Q for
the quarter ended March 31, 2002, and hereby incorporated by reference.                                                                                            
|       | 
|10.8   |  | Asset Purchase Agreement among Deluxe Media Services, Inc. the Registrant, Sonic Foundry Media Services, Inc. and International Image Services, Inc., dated April 30, 2003 filed as Exhibit
99.2 to Form 8-K filed on May 21, 2003, and hereby incorporated by reference.                                                                                       
|       | 
|10.9   |  | Amended and Restated Asset Purchase Agreement, incorporated by reference from Appendix A of Schedule 14A filed on June 19, 2003 and hereby incorporated by reference.                                                                                                                                                                                           
|       | 
|10.10  |  | Commercial Lease between West Washington Associates LLC and Sonic Foundry, Inc. regarding 222 West Washington Ave., Suite 775, Madison, WI, dated August 1, 2003 filed as Exhibit 10.21 to Form
10-K filed on December 23, 2003 and hereby incorporated by reference.                                                                                           
|       | 
|31.1   |  | Section 302 Certification of Chief Executive Officer                                                                                                                                                                                                                                                                                                            



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|     |  |                                                                                 
|---- |  | --------------------------------------------------------------------------------
|31.2 |  | Section 302 Certification of Chief Financial Officer                            
|     | 
|32   |  | Section 906 Certification of Chief Executive Officer and Chief Financial Officer



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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|* | Compensatory Plan or Arrangement
|- | --------------------------------



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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.



|                 |  |                     |  |                                      
|---------------- |  | ------------------- |  | -------------------------------------
|                 |  | Sonic Foundry, Inc.
|                 |  | (Registrant)       
|                 |  |                    
|February 3, 2005 |  | By:                 |  | /s/ Rimas P. Buinevicius             
|                 |  |                     |  | Rimas P. Buinevicius                 
|                 |  |                     |  | Chairman and Chief Executive Officer 
|                 |  |                    
|February 3, 2005 |  | By:                 |  | /s/ Kenneth A. Minor                 
|                 |  |                     |  | Kenneth A. Minor                     
|                 |  |                     |  | Chief Financial Officer and Secretary



17