##### Table of Contents

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



---



FORM 10-Q



---



(Mark One)

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



For the Quarterly period ended March 31, 2004



OR



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



Commission File Number 1-14007



---



SONIC FOUNDRY, INC.

(Exact name of registrant as specified in its charter)



---



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|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)



---



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  x    No ̈



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



|                              |  |                        
|----------------------------- |  | -----------------------
|Class                         |  | Outstanding May 6, 2004
|Common Stock, $0.01 par value |  | 29,577,800             



---



---

##### Table of Contents

TABLE OF CONTENTS



|        |  |                                                                                                               |  |         
|------- |  | ------------------------------------------------------------------------------------------------------------- |  | --------
|        |  |                                                                                                               |  | PAGE NO.
|PART I  |  | FINANCIAL INFORMATION                                                                                         |  |         
|        |  |                                                                                                              
|Item 1. |  | Consolidated Financial Statements                                                                             |  |         
|        |  |                                                                                                              
|        |  | Consolidated Balance Sheets  March 31, 2004(Unaudited) and September 30, 2003                                |  | 3       
|        |  |                                                                                                              
|        |  | Consolidated Statements of Operations (Unaudited)  Three months and six months ended March 31, 2004 and 2003 |  | 4       
|        |  |                                                                                                              
|        |  | Consolidated Statements of Cash Flows (Unaudited)  Six months ended March 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                                                    |  | 14      
|        |  |                                                                                                              
|Item 4. |  | Controls and Procedures                                                                                       |  | 15      
|        |  |                                                                                                              
|PART II |  | OTHER INFORMATION                                                                                             |  |         
|        |  |                                                                                                              
|Item 6. |  | Exhibits and Reports on Form 8-K                                                                              |  | 15      



2



---

##### Table of Contents

Sonic Foundry, Inc.

Consolidated Balance Sheets

(in thousands except for share data)



|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                                               |  | March 31,2004 |          |   | September30, 2003 |  
|                                                                                                                                                                                               |  | (unaudited)   |          |   |                   |  
|Assets                                                                                                                                                                                         |  |               |          |   |                   |   |          |  
|Current Assets:                                                                                                                                                                                |  |               |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                                      |  | $             | 4,043    |   |                   | $ | 12,623   |  
|Short-term investments                                                                                                                                                                         |  |               | 7,000    |   |                   |   |         |  
|Accounts receivable, net of allowances of $30 and $40                                                                                                                                          |  |               | 602      |   |                   |   | 508      |  
|Accounts receivable, other                                                                                                                                                                     |  |               | 2        |   |                   |   | 139      |  
|Inventories                                                                                                                                                                                    |  |               | 68       |   |                   |   | 111      |  
|Prepaid expenses and other current assets                                                                                                                                                      |  |               | 419      |   |                   |   | 214      |  
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Total current assets                                                                                                                                                                           |  |               | 12,134   |   |                   |   | 13,595   |  
|Property and equipment:                                                                                                                                                                        |  |               |          |   |                   |   |          |  
|Leasehold improvements                                                                                                                                                                         |  |               | 129      |   |                   |   | 132      |  
|Computer equipment                                                                                                                                                                             |  |               | 853      |   |                   |   | 741      |  
|Furniture and fixtures                                                                                                                                                                         |  |               | 151      |   |                   |   | 96       |  
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Total property and equipment                                                                                                                                                                   |  |               | 1,133    |   |                   |   | 969      |  
|Less accumulated depreciation                                                                                                                                                                  |  |               | 490      |   |                   |   | 381      |  
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Net property and equipment                                                                                                                                                                     |  |               | 643      |   |                   |   | 588      |  
|Other assets:                                                                                                                                                                                  |  |               |          |   |                   |   |          |  
|Goodwill and other intangibles, net                                                                                                                                                            |  |               | 7,701    |   |                   |   | 7,726    |  
|Capitalized software development costs, net of amortization of $648 and $508                                                                                                                   |  |               | 752      |   |                   |   | 892      |  
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Total other assets                                                                                                                                                                             |  |               | 8,453    |   |                   |   | 8,618    |  
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Total assets                                                                                                                                                                                   |  | $             | 21,230   |   |                   | $ | 22,801   |  
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Liabilities and stockholders equity                                                                                                                                                           |  |               |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                                                           |  |               |          |   |                   |   |          |  
|Accounts payable                                                                                                                                                                               |  | $             | 696      |   |                   | $ | 1,065    |  
|Accrued liabilities                                                                                                                                                                            |  |               | 676      |   |                   |   | 1,263    |  
|Unearned revenue                                                                                                                                                                               |  |               | 354      |   |                   |   | 194      |  
|Current portion of capital lease obligations                                                                                                                                                   |  |               | 28       |   |                   |   | 48       |  
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                                      |  |               | 1,754    |   |                   |   | 2,570    |  
|                                                                                                                                                                                               |  |              
|Deferred rent                                                                                                                                                                                  |  |               | 30       |   |                   |   |         |  
|                                                                                                                                                                                               |  |              
|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; 29,599,550 and 28,684,449 issued and 29,529,300 and 28,614,199 outstanding at
March 31, 2004 and September 30, 2003, respectively |  |               | 296      |   |                   |   | 287      |  
|Additional paid-in capital                                                                                                                                                                     |  |               | 169,235  |   |                   |   | 168,106  |  
|Accumulated deficit                                                                                                                                                                            |  |               | (149,891 | ) |                   |   | (147,532 | )
|Receivable for common stock issued                                                                                                                                                             |  |               | (26      | ) |                   |   | (462     | )
|Treasury stock, at cost, 70,250 shares                                                                                                                                                         |  |               | (168     | ) |                   |   | (168     | )
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                                                     |  |               | 19,446   |   |                   |   | 20,231   |  
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                                                     |  | $             | 21,230   |   |                   | $ | 22,801   |  
|                                                                                                                                                                                               |  |               |          |   |                   |   |          |  

See accompanying notes



3



---

##### Table of Contents

Sonic Foundry, Inc

Statements of Operations

(in thousands except for share data)

(Unaudited)



|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                                                            |  | Three Months Ended March 31, |        |   | Six Months Ended March 31, |  
|                                                                                                                                            |  | 2004                         |        |   | 2003                       |   |        | 2004 |  |   | 2003   |  
|Continuing Operations                                                                                                                       |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Revenue:                                                                                                                                    |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Product sales                                                                                                                               |  | $                            | 691    |   |                            | $ | 192    |      |  | $ | 1,294  |   |  | $ | 365    |  
|Customer support fees                                                                                                                       |  |                              | 90     |   |                            |   | 26     |      |  |   | 156    |   |  |   | 26     |  
|Other                                                                                                                                       |  |                              | 160    |   |                            |   |       |      |  |   | 390    |   |  |   |       |  
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total revenue                                                                                                                               |  |                              | 941    |   |                            |   | 218    |      |  |   | 1,840  |   |  |   | 391    |  
|Cost of revenue                                                                                                                             |  |                              | 431    |   |                            |   | 186    |      |  |   | 755    |   |  |   | 343    |  
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Gross margin                                                                                                                                |  |                              | 510    |   |                            |   | 32     |      |  |   | 1,085  |   |  |   | 48     |  
|                                                                                                                                            |  |                              |        |  
|Operating expenses:                                                                                                                         |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Selling and marketing expenses                                                                                                              |  |                              | 798    |   |                            |   | 560    |      |  |   | 1,546  |   |  |   | 1,487  |  
|General and administrative expenses                                                                                                         |  |                              | 644    |   |                            |   | 652    |      |  |   | 1,325  |   |  |   | 1,363  |  
|Product development expenses                                                                                                                |  |                              | 393    |   |                            |   | 336    |      |  |   | 761    |   |  |   | 806    |  
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total operating expense                                                                                                                     |  |                              | 1,835  |   |                            |   | 1,548  |      |  |   | 3,632  |   |  |   | 3,656  |  
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Loss from operations                                                                                                                        |  |                              | (1,325 | ) |                            |   | (1,516 | )    |  |   | (2,547 | ) |  |   | (3,608 | )
|Other income (expense), net                                                                                                                 |  |                              | 22     |   |                            |   | (4     | )    |  |   | 56     |   |  |   | 1      |  
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Loss from continuing operations                                                                                                             |  |                              | (1,303 | ) |                            |   | (1,520 | )    |  |   | (2,491 | ) |  |   | (3,607 | )
|                                                                                                                                            |  |                              |        |  
|Discontinued operations:                                                                                                                    |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Loss from operations of discontinued operations including $0 and $89 of income tax benefit in the three and six months ended March 31,
2003 |  |                              |       |   |                            |   | (585   | )    |  |   |       |   |  |   | (1,845 | )
|Gain on disposal of discontinued operations                                                                                                 |  |                              | 12     |   |                            |   |       |      |  |   | 132    |   |  |   |       |  
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) from discontinued operations                                                                                                  |  |                              | 12     |   |                            |   | (585   | )    |  |   | 132    |   |  |   | (1,845 | )
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Net loss                                                                                                                                    |  | $                            | (1,291 | ) |                            | $ | (2,105 | )    |  | $ | (2,359 | ) |  | $ | (5,452 | )
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Loss per common share:                                                                                                                      |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Continuing operations                                                                                                                       |  | $                            | (0.04  | ) |                            | $ | (0.05  | )    |  | $ | (0.08  | ) |  | $ | (0.13  | )
|Discontinued operations                                                                                                                     |  |                              | (0.00  | ) |                            |   | (0.03  | )    |  |   | (0.00  | ) |  |   | (0.07  | )
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Net loss per common share  basic and diluted                                                                                               |  | $                            | (0.04  | ) |                            | $ | (0.08  | )    |  | $ | (0.08  | ) |  | $ | (0.20  | )
|                                                                                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  

See accompanying notes



4



---

##### Table of Contents

|                                                                                    
|------------------------------------------------------------------------------------
|Sonic Foundry, Inc. Consolidated Statements of Cash Flows (in thousands) (Unaudited)

|                                                                             |  |                            |        |   |      |   |        |  
|---------------------------------------------------------------------------- |  | -------------------------- | ------ | - | ---- | - | ------ | -
|                                                                             |  | Six months ended March 31, |       
|                                                                             |  | 2004                       |        |   | 2003 |  
|Operating activities                                                         |  |                            |        |   |      |   |        |  
|Net loss                                                                     |  | $                          | (2,359 | ) |      | $ | (5,452 | )
|Adjustments to reconcile net loss to net cash used in operating activities:  |  |                            |        |   |      |   |        |  
|Gain on sale of discontinued operations                                      |  |                            | (132   | ) |      |   |       |  
|Amortization of intangible assets and capitalized software development costs |  |                            | 165    |   |      |   | 225    |  
|Depreciation and amortization of property and equipment                      |  |                            | 109    |   |      |   | 1,656  |  
|Amortization of debt discount and debt issue costs                           |  |                            |       |   |      |   | 2,006  |  
|Noncash compensation charges and charges for stock warrants and options      |  |                            | 114    |   |      |   | 49     |  
|Loss on sale of property and equipment                                       |  |                            |       |   |      |   | 12     |  
|Changes in operating assets and liabilities:                                 |  |                            |        |   |      |   |        |  
|Accounts receivable                                                          |  |                            | (94    | ) |      |   | 583    |  
|Accounts receivable, other                                                   |  |                            | 137    |   |      |   | (48    | )
|Inventories                                                                  |  |                            | 43     |   |      |   | (41    | )
|Prepaid expenses and other assets                                            |  |                            | (164   | ) |      |   | 222    |  
|Accounts payable, accrued liabilities and deferred rent                      |  |                            | (926   | ) |      |   | (828   | )
|Unearned revenue                                                             |  |                            | 160    |   |      |   | 25     |  
|                                                                             |  |                            |        |   |      |   |        |  
|Total adjustments                                                            |  |                            | (588   | ) |      |   | 3,861  |  
|                                                                             |  |                            |        |   |      |   |        |  
|Net cash used in operating activities                                        |  |                            | (2,947 | ) |      |   | (1,591 | )
|                                                                             |  |                           
|Investing activities                                                         |  |                            |        |   |      |   |        |  
|Purchase of short-term investments                                           |  |                            | (7,000 | ) |      |   |       |  
|Proceeds from sale of discontinued operations, net                           |  |                            | 132    |   |      |   |       |  
|Proceeds from sale of property and equipment                                 |  |                            |       |   |      |   | 15     |  
|Purchases of property and equipment                                          |  |                            | (164   | ) |      |   | (37    | )
|                                                                             |  |                            |        |   |      |   |        |  
|Net cash used in investing activities                                        |  |                            | (7,032 | ) |      |   | (22    | )
|                                                                             |  |                           
|Financing activities                                                         |  |                            |        |   |      |   |        |  
|Proceeds from issuance of common stock, net of issuance costs                |  |                            | 1,419  |   |      |   | 38     |  
|Proceeds from debt issuances                                                 |  |                            |       |   |      |   | 1,069  |  
|Payments on long-term debt and capital leases                                |  |                            | (20    | ) |      |   | (1,565 | )
|Payments on line of credit, net                                              |  |                            |       |   |      |   | (451   | )
|                                                                             |  |                            |        |   |      |   |        |  
|Net cash provided by (used in) financing activities                          |  |                            | 1,399  |   |      |   | (909   | )
|Effect of exchange rate changes on cash                                      |  |                            |       |   |      |   | 51     |  
|                                                                             |  |                            |        |   |      |   |        |  
|Net decrease in cash                                                         |  |                            | (8,580 | ) |      |   | (2,471 | )
|Cash and cash equivalents at beginning of period                             |  |                            | 12,623 |   |      |   | 3,704  |  
|                                                                             |  |                            |        |   |      |   |        |  
|Cash and cash equivalents at end of period                                   |  | $                          | 4,043  |   |      | $ | 1,233  |  
|                                                                             |  |                            |        |   |      |   |        |  
|Supplemental cash flow information:                                          |  |                            |        |   |      |   |        |  
|Interest paid                                                                |  |                            |       |   |      |   | (381   | )
|Income taxes refunded (paid)                                                 |  |                            | (79    | ) |      |   | 180    |  
|Non-cash transactions -                                                      |  |                            |        |   |      |   |        |  
|Capital lease acquisitions                                                   |  |                            |       |   |      |   | 38     |  



See accompanying notes



5



---

##### Table of Contents

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 Media Systems business). Our current operations were formed in October 2001
when we acquired the assets and assumed certain liabilities of Mediasite, Inc. (Mediasite). 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 recently, we were engaged in three businesses  Media Services, Desktop Software and Media Systems. Our media services operation (Media
Services) provided format conversion, tape duplication, film restoration and other services to the media, broadcast and entertainment industries. On May 16, 2003, the Company completed the sale of the Media Services business to Deluxe Media
Services.



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



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



Interim Financial Data



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



Revenue Recognition



General



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



Product Sales



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



Customer Support Fees



We sell support contracts to customers of MSL, 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 as well as an extension of the
standard hardware warranty from 90 days to one year. Hardware warranty service is performed by the manufacturer we contract with to build the units. Time and material contracts, such as training fees, are recognized as revenue when services are
rendered. Service amounts invoiced to customers in excess of revenue recognized are recorded as unearned revenue until the revenue recognition criteria are met.



6



---

##### Table of Contents

Other



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



Revenue Arrangements that Include Multiple Elements



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



Shipping and Handling



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



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 finished MSL units and raw materials used in the repair and assembly of MSL units.



Stock Based Compensation



As permitted by SFAS No. 123, Accounting for Stock-Based
Compensation, the Company follows Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, in accounting for its stock option plans. Had the Company accounted for its stock option plans based upon the
fair value at the grant date for options granted under the plan, based on the provisions of SFAS No. 123, 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):



|                                                                          |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                          |  | Three Months Ended March 31, |        |   | Six Months Ended March 31, |  
|                                                                          |  | 2004                         |        |   | 2003                       |   |        | 2004 |  |   | 2003   |  
|Net loss as reported                                                      |  | $                            | (1,291 | ) |                            | $ | (2,105 | )    |  | $ | (2,359 | ) |  | $ | (5,452 | )
|Stock-based compensation using fair value method                          |  |                              | (90    | ) |                            |   | (137   | )    |  |   | (112   | ) |  |   | (415   | )
|Impact of discounted employee stock purchase plan using fair value method |  |                              |       |   |                            |   |       |      |  |   | (4     | ) |  |   | (11    | )
|                                                                          |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Pro forma net loss                                                        |  | $                            | (1,381 | ) |                            | $ | (2,242 | )    |  | $ | (2,475 | ) |  | $ | (5,878 | )
|Pro forma net loss per share  basic and diluted                          |  | $                            | (0.05  | ) |                            | $ | (0.08  | )    |  | $ | (0.08  | ) |  | $ | (0.21  | )



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 2.59 and a weighted-average expected life of the option of one to five years.



7



---

##### Table of Contents

Per share computation



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



|                                                                                                                                                   |  |                              |  |                            |  |            |  |           
|-------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------- |  | -------------------------- |  | ---------- |  | ----------
|                                                                                                                                                   |  | Three Months Ended March 31, |  | Six Months Ended March 31,
|                                                                                                                                                   |  | 2004                         |  | 2003                       |  | 2004       |  | 2003      
|Denominator                                                                                                                                        |  |                              |  |                            |  |            |  |           
|Denominator for basic and diluted loss per share  weighted average common shares                                                                  |  | 29,397,443                   |  | 27,784,509                 |  | 29,294,214 |  | 27,743,519
|Securities outstanding at the end of each period, but not included in the computation of diluted earnings per share because they are
antidilutive: |  |                              |  |                            |  |            |  |           
|Options and warrants                                                                                                                               |  | 6,584,702                    |  | 8,458,163                  |  | 6,584,702  |  | 8,458,163 
|Convertible subordinated debt                                                                                                                      |  |                             |  | 2,908,162                  |  |           |  | 2,908,162 



Accounting Pronouncements



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



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



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



2. Managements Plan and Discontinued Operations



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



8



---

##### Table of Contents

Media Services



The Company completed the sale of assets utilized in the Media Services business on May 16, 2003 with Deluxe Media Services (Deluxe). The
transaction included all assets utilized in the Companys Media Services business primarily affecting business conducted from and employees in the Companys Santa Monica California and Toronto Canada facilities. Under terms of the
agreement, Deluxe acquired the Media Services business for approximately $5.6 million including cash of $4.5 million plus an estimate of $1.1 million for net working capital and assumption of certain capital leases. The Company received $5.2 million
at close with the remainder due upon a final determination of actual working capital. The Company received $350 thousand of the remainder in September 2003 and settled on a final payment of $241 thousand in January 2004. The Company recorded a gain
on sale of discontinued operations of $185 thousand in 2004 to reflect the amount that the January 2004 payment and other settlements exceeded the working capital estimates. Overall, the disposition of the Media Services business resulted in a
cumulative loss of $1.8 million. Details of the discontinued Media Services business are as follows (in thousands):



|                     |  |                              |  |      |                            |   |      |   |      |   |        |  
|-------------------- |  | ---------------------------- |  | ---- | -------------------------- | - | ---- | - | ---- | - | ------ | -
|                     |  | Three Months Ended March 31, |  |      | Six Months Ended March 31, |  
|                     |  | 2004                         |  | 2003 |                            |   | 2004 |   | 2003 |  
|Revenues             |  |                             |  | $    | 2,033                      |   |      |  |      | $ | 3,945  |  
|Cost of revenues     |  |                             |  |      | 1,615                      |   |      |  |      |   | 3,266  |  
|                     |  |                              |  |      |                            |   |      |   |      |   |        |  
|Gross margin         |  |                             |  |      | 418                        |   |      |  |      |   | 679    |  
|Operating expenses   |  |                             |  |      | 963                        |   |      |  |      |   | 2,079  |  
|                     |  |                              |  |      |                            |   |      |   |      |   |        |  
|Operating loss       |  |                             |  |      | (545                       | ) |      |  |      |   | (1,400 | )
|Other income         |  |                             |  |      | 1                          |   |      |  |      |   | 69     |  
|                     |  |                              |  |      |                            |   |      |   |      |   |        |  
|Loss from operations |  |                             |  | $    | (544                       | ) |      |  |      | $ | (1,331 | )
|                     |  |                              |  |      |                            |   |      |   |      |   |        |  



Desktop Software



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



|                     |  |                              |  |      |                            |   |      |   |      |   |        |  
|-------------------- |  | ---------------------------- |  | ---- | -------------------------- | - | ---- | - | ---- | - | ------ | -
|                     |  | Three Months Ended March 31, |  |      | Six Months Ended March 31, |  
|                     |  | 2004                         |  | 2003 |                            |   | 2004 |   | 2003 |  
|Revenues             |  |                             |  | $    | 4,103                      |   |      |  |      | $ | 8,051  |  
|Cost of revenues     |  |                             |  |      | 712                        |   |      |  |      |   | 1,386  |  
|                     |  |                              |  |      |                            |   |      |   |      |   |        |  
|Gross margin         |  |                             |  |      | 3,391                      |   |      |  |      |   | 6,665  |  
|Operating expenses   |  |                             |  |      | 2,238                      |   |      |  |      |   | 4,647  |  
|                     |  |                              |  |      |                            |   |      |   |      |   |        |  
|Operating income     |  |                             |  |      | 1,153                      |   |      |  |      |   | 2,018  |  
|Other expense        |  |                             |  |      | (1,194                     | ) |      |  |      |   | (2,532 | )
|                     |  |                              |  |      |                            |   |      |   |      |   |        |  
|Loss from operations |  |                             |  | $    | (41                        | ) |      |  |      | $ | (514   | )
|                     |  |                              |  |      |                            |   |      |   |      |   |        |  



3. Related Party Transactions



During the quarter ended March 31, 2004, the Company
recorded MSL product revenue of $48 thousand to MSKK, a Japanese reseller in which the Company has a 33% equity interest.



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, 2003. In addition to historical information, this discussion
contains forward-looking statements such as statements of the Companys expectations, plans, objectives and beliefs. These statements use such words as may, will, expect, anticipate,
believe, plan, and other similar terminology.



Actual results could differ materially 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 mult-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 factors which may be identified from time to time in Sonic Foundrys Securities and Exchange Commission filings and other public announcements.



9



---

##### Table of Contents

Overview



Sonic Foundry, Inc. is in the business of developing automated rich-media application software and systems, (our Media Systems business). The
Media Systems business was formed in October 2001, when our wholly-owned subsidiary, Sonic Foundry Systems Group, Inc. acquired the assets and assumed certain liabilities of Mediasite. 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 MSL, a web presentation system and Publisher, a software product for creating accessible and searchable rich media presentations.



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



Critical Accounting Policies



We have identified the following as critical accounting policies of 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 MSL 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
No. 144 requires that long-lived assets and intangible assets other than goodwill be evaluated for impairment whenever events or changes in circumstances



10



---

##### Table of Contents

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. A valuation allowance equal to 100% of the net deferred tax assets has been recognized due to uncertainty regarding future realization.



Results of Continuing Operations



Revenue



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



Q2-2004 compared to Q2-2003



Revenues in Q2-2004 totaled $941 thousand compared to Q2-2003 sales of $218 thousand. Revenues consisted of the following:



| |  | $691 thousand product revenue from the sale of 66 MSL units versus $192 thousand from the sale of 22 MSL units in 2003.
| | - | -----------------------------------------------------------------------------------------------------------------------



| |  | $90 thousand from MSL service plans. Service plans are typically 18% of the product sales price and recognized over the term (usually 12 months) of the service contract. Service
amortization in 2003 amounted to $26 thousand. As of March 31, 2004 our balance in unamortized service contracts was $354 thousand. We will recognize approximately $100 thousand of that balance in the upcoming quarter.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | $64 thousand from the research grant with the Department of Justice. To date, we have recognized $114 thousand from the grant total of nearly $500 thousand. The remainder is
expected to be recognized over the next 4 to 5 quarters as costs are incurred.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | $91 thousand of Mediasite Publisher license fees and related consulting services to suppliers of the Federal government.
| | - | ------------------------------------------------------------------------------------------------------------------------



YTD-2004 (six months) compared to YTD-2003 (six months)



Revenues for YTD-2004 totaled $1.84 million compared to YTD-2003 sales
of $391 thousand. Revenues consisted of the following:



| |  | $1.3 million product revenue from the sale of 110 MSL units versus $365 thousand from the sale of 39 MSL units in 2003.
| | - | -----------------------------------------------------------------------------------------------------------------------



| |  | $156 thousand from MSL service plans versus $26 thousand in 2003.
| | - | -----------------------------------------------------------------



| |  | $114 thousand from the research grant from the Department of Justice.
| | - | ---------------------------------------------------------------------



| |  | $238 thousand of Mediasite Publisher license fees and related consulting services to suppliers of the Federal Government.
| | - | -------------------------------------------------------------------------------------------------------------------------



Gross Margin



The significant components of cost of systems include:



| |  | Material and freight costs for the MSL units. Costs for Q2-2004 and YTD-2004 amounted to $338 thousand and $568 thousand, which resulted in MSL gross margins  excluding
support revenue  of 51% and 56%. The gross margin on MSL sales varies with product and customer mix; our rack mount (RL) units carry a higher margin than our mobile units (ML) and we offer reduced pricing on units used
to establish new markets such as ASP, and to demonstrate MSL to end customers. In Q2-2004, margins were reduced due to a 2.5 to 1 ratio of ML units sold to RL units sold. The ratio in Q1-2004 was 1.5 to 1. We expect margins for the remainder of
Fiscal 2004 to increase from Q2-2004 as the ratio of ML units to RL units decreases due to: 1) a declining percentage of ML unit sales (to total sales) for demonstration purposes; and 2) an increasing number of RL units sold for installation in the
higher education market. We expect that MSL margins will exceed 56% in the upcoming quarters.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



11



---

##### Table of Contents

| |  | Amortization of Mediasite acquisition amounts assigned to purchased technology and other identified intangibles. We will amortize approximately $85 thousand per quarter over the
next 3 years for the identified intangibles of the Mediasite purchase.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Royalties to Carnegie Mellon University on the sales of Mediasite Publisher technology. Royalties for Q1-2004 and Q2-2004 were $9 thousand and $2 thousand.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------



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 other 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.



Q2-2004 compared to Q2-2003



The $238 thousand or 42% increase from Q2-2004 to Q2-2003 resulted from numerous items.
Significant differences included:



| |  | Growth in revenues led to an increase in commissions, other sales incentives and recruiting costs for additional regional sales managers to $76 thousand in Q2-2004, a $60 thousand
increase from Q2-2003.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Professional fees to research groups, state and federal government lobbyists and to our public relations firm amounted to over $100 thousand in Q2-2004, a $60 increase over the
prior year. In Q2-2004 we issued 50,000 warrants valued at approximately $90 thousand to a public relations firm. The value of the warrants is being amortized over the 11 month term of a services agreement. $16 thousand of non-cash amortization is
included in the Q2-2004 total.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Travel & reseller development expenses increased in Q2-2004 by nearly $50 thousand over the prior year, primarily due to: 1) a training and informational workshop we sponsored
for existing resellers; and 2) tradeshow attendance.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



YTD-2004 compared to YTD-2003



The $59 thousand or 4%
increase from YTD-2004 to YTD-2003 resulted from increases in many of the same items mentioned in the quarter discussion above, offset by Q1-2003 severance expense of just over $300 thousand related to the elimination of two executive level
positions. YTD increases in the major categories include:



| |  | YTD-2004 commissions, other sales incentives and recruiting exceeded YTD-2003 by over $100 thousand due to the growth in revenues.
| | - | ----------------------------------------------------------------------------------------------------------------------------------



| |  | YTD-2004 fees to research groups, state and federal government lobbyists and our public relations firm amounted to $220 thousand, a $150 thousand increase over the prior year.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | YTD-2004 travel & reseller development expenses increased by nearly $50 thousand over the prior year.
| | - | -----------------------------------------------------------------------------------------------------



| |  | YTD-2004 cost associated with increasing the pool of internal demonstration and key account loaner equipment amounted to approximately $65 thousand.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------



As of March 31, 2004 we had 15 employees in Selling and Marketing, including three new
regional sales positions. We anticipate adding 5 - 10 additional people in the upcoming quarters in order to pursue sales growth in additional regions and support a growing number of customers. Due to the addition of staff, planned attendance at a
June tradeshow and other initiatives, we anticipate selling and marketing to increase over 10% in the upcoming quarter.



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.



Q2-2004 compared to Q2-2003



G&A decreased $8 thousand or 1% from Q2-2003 to Q2-2004. With the exception of professional fees and insurance premiums, unallocated G&A costs remained fairly constant from period to period. Professional fees
(accounting, legal, consulting, advisory board and transfer/registration fees) and insurance premiums made up 53% of the Q2-2004 G&A total while salaries and benefits were 35%. Advisory board fees include $39 thousand of non-cash fees related to
issuance of warrants.



12



---

##### Table of Contents

YTD-2004 compared to YTD-2003



G&A decreased $38 thousand or 3% from YTD-2003 to YTD-2004. As mentioned in the quarter discussion above, with the
exception of professional fees and insurance premiums, unallocated G&A costs remained fairly constant from period to period. Professional fees (accounting, legal, consulting, advisory board and transfer/registration fees) and insurance premiums
made up 52% of the YTD-2004 G&A total while salaries and benefits were 33%. Advisory board fees include $72 thousand of non-cash fees related to issuance of warrants.



As of March 31, 2004 we had 8 full-time employees in G&A. There are no near term plans to expand these departments.
G&A expenses are also expected to remain fairly 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.



Q2-2004 compared to Q2-2003



Q2-2004 R&D expenses increased $57 thousand, or
17% from Q2-2003. In 2004-Q1 we hired additional engineers in order to accelerate development of enhancements to our existing MSL product as well as development of channel specific add-on components and future versions of the MSL product. We also
added additional employees to staff the Department of Justice and other contract work. In Q2-2004, 80% of R&D costs related to salaries and benefits.



YTD-2004 compared to YTD-2003



YTD-2004 R&D expenses decreased $45 thousand, or 6% from YTD-2003. Attrition and workforce reductions of the now closed Pittsburgh location more than
offset the recent growth in staff. The prior year reduction in staff reflected a decision to focus on the MSL product and offer no near term upgrades of the Mediasite Publisher product. In YTD-2004, 81% of R&D costs related to salaries and
benefits.



As of March 31, 2004 we had 15 employees in Research
and Development. We anticipate growing R&D by an additional 5  10 people over the next year. We do not anticipate that any fiscal 2004 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 a short-term bond mutual fund, certificates of deposit and overnight investment vehicles.



Discontinued Operations



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



Details of the discontinued Media Services business are as follows:



|                     |  |                             |  |      |                           |   |      |   |      |   |        |  
|-------------------- |  | --------------------------- |  | ---- | ------------------------- | - | ---- | - | ---- | - | ------ | -
|                     |  | Three Months EndedMarch 31, |  |      | Six Months EndedMarch 31, |  
|                     |  | 2004                        |  | 2003 |                           |   | 2004 |   | 2003 |  
|Revenues             |  |                            |  | $    | 2,033                     |   |      |  |      | $ | 3,945  |  
|Cost of revenues     |  |                            |  |      | 1,615                     |   |      |  |      |   | 3,266  |  
|                     |  |                             |  |      |                           |   |      |   |      |   |        |  
|Gross margin         |  |                            |  |      | 418                       |   |      |  |      |   | 679    |  
|Operating expenses   |  |                            |  |      | 963                       |   |      |  |      |   | 2,079  |  
|                     |  |                             |  |      |                           |   |      |   |      |   |        |  
|Operating loss       |  |                            |  |      | (545                      | ) |      |  |      |   | (1,400 | )
|Other income         |  |                            |  |      | 1                         |   |      |  |      |   | 69     |  
|                     |  |                             |  |      |                           |   |      |   |      |   |        |  
|Loss from operations |  |                            |  | $    | (544                      | ) |      |  |      | $ | (1,331 | )
|                     |  |                             |  |      |                           |   |      |   |      |   |        |  



13



---

##### Table of Contents

Details of discontinued Desktop Software business are as follows:



|                     |  |                             |  |      |                           |   |      |   |      |   |        |  
|-------------------- |  | --------------------------- |  | ---- | ------------------------- | - | ---- | - | ---- | - | ------ | -
|                     |  | Three Months EndedMarch 31, |  |      | Six Months EndedMarch 31, |  
|                     |  | 2004                        |  | 2003 |                           |   | 2004 |   | 2003 |  
|Revenues             |  |                            |  | $    | 4,103                     |   |      |  |      | $ | 8,051  |  
|Cost of revenues     |  |                            |  |      | 712                       |   |      |  |      |   | 1,386  |  
|                     |  |                             |  |      |                           |   |      |   |      |   |        |  
|Gross margin         |  |                            |  |      | 3,391                     |   |      |  |      |   | 6,665  |  
|Operating expenses   |  |                            |  |      | 2,238                     |   |      |  |      |   | 4,647  |  
|                     |  |                             |  |      |                           |   |      |   |      |   |        |  
|Operating income     |  |                            |  |      | 1,153                     |   |      |  |      |   | 2,018  |  
|Other expense        |  |                            |  |      | (1,194                    | ) |      |  |      |   | (2,532 | )
|                     |  |                             |  |      |                           |   |      |   |      |   |        |  
|Loss from operations |  |                            |  | $    | (41                       | ) |      |  |      | $ | (514   | )
|                     |  |                             |  |      |                           |   |      |   |      |   |        |  



Liquidity and Capital Resources



Cash used in operating activities was $2.9 million for
YTD-2004 compared to $1.6 million in YTD-2003. Significant YTD-2004 outflows included: 1) $926 thousand decrease in accounts payable and accrued liabilities that had accumulated prior to the Desktop Software transaction; 2) a $160 thousand increase
in unearned revenue related to MSL service plans; and 3) an increase in prepaid assets primarily related to $100 thousand of tax deposits. In YTD-2003 we had significant cash flows from the collection of accounts receivable related to the Desktop
Software business and the release of a new upgrade to a Desktop Software product.



Cash used in investing activities was $7.0 million in YTD-2004 and nearly $0 in YTD-2003. The $7.0 million of short-term investments at March 31, 2004 include a short-term bond mutual fund and certificates of deposit
maturing between September 2004 and March 2005. We anticipate maintaining short-term investments in the 3 to 12 month range. Investing activities for the current year also included net proceeds from the final settlements from the sales of the
Companys Media Services and Desktop Software businesses.



Cash provided by financing activities was $1.4 million in YTD-2004. Nearly the entire amount received related to option and warrant exercise proceeds. The majority of option and warrant holders who exercised were employees terminated in the
Desktop Software transaction. In Q1-2004, we also received $10 thousand in proceeds from our Employee Stock Purchase Plan. Prior activity included significant debt, interest and capital lease payments, offset by borrowed funds. All debt and all but
$48 thousand of capital leases were paid off at or soon after the closing of the Desktop Software sale.



We believe we can fund at least 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.



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 cost which approximates fair value. Accordingly, we believe that the market
risk of such investments is minimal.



Interest Rate Risk



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



14



---

##### Table of Contents

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 March 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 regulations of the SEC.



Changes in Internal Controls



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



PART II OTHER INFORMATION



Item 6. EXHIBITS AND REPORTS ON FORM 8-K



|(a) | Exhibits (see exhibit list)
|--- | ---------------------------



|(b) | Report on Form 8-K
|--- | ------------------



On February 12, 2004, Registrant filed a report dated February 12, 2004 on Item 9 of Form 8-K with respect to first quarter fiscal 2004 financial results.
No financial statements were filed with this report.



ITEM 6(a)



|       |  |                                                                                                                                                                                                                                                                        
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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.                                       



15



---

##### Table of Contents

|      |  |                                                                                                                                                                                                                                                                                                                                                                 
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      | 
|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  |  | Commercial Lease between Stonewood East and Sonic Foundry Media Systems, Inc. regarding 12300 Perry Highway, Wexford, PA, dated January 13, 2002 filed as Exhibit No. 10.24 to the Quarterly
Report on Form 10-Q for the quarter ended March 31, 2002, and hereby incorporated by reference.                                                                    
|      | 
|10.7* |  | Registrants 2001 Deferred Compensation Plan, filed as Exhibit 4.4 to Form S-8 on November 21, 2001 and hereby incorporated by reference.                                                                                                                                                                                                                       
|      | 
|10.8* |  | 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.                                                                                                                                                                                                                      
|      | 
|10.9  |  | 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.                                                                                            
|      | 
|10.10 |  | Warrant Agreement filed as Exhibit 10.1 to Registration Statement No. 333-98795 on Form S-3 filed on August 27, 2002 and hereby incorporated by reference.                                                                                                                                                                                                      
|      | 
|10.11 |  | Promissory Note between Registrant and Aris A. Buinevicius and Claire Horne for $1,250,000 dated November 18, 2002 filed as Exhibit No. 10.27 to the Quarterly Report on Form 10-Q for the
quarter ended December 31, 2002 and hereby incorporated by reference.                                                                                                
|      | 
|10.12 |  | 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.                                                                                       
|      | 
|10.13 |  | 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.                                                                                                                                                                                           
|      | 
|10.14 |  | 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                                                                                                                                                                                                                                                                                                            
|      | 
|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.



---

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



16



---

##### Table of Contents

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)       
|             |  |                    
|May 11, 2004 |  | By:                 |  | /s/ Rimas P. Buinevicius             
|             |  |                     |  | Rimas P. Buinevicius                 
|             |  |                     |  | Chairman and Chief Executive Officer 
|             |  |                    
|May 11, 2004 |  | By:                 |  | /s/ Kenneth A. Minor                 
|             |  |                     |  | Kenneth A. Minor                     
|             |  |                     |  | Chief Financial Officer and Secretary



17