**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

**(Mark one)**

**x        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF1934**

 

**For the quarterly periodended April 30, 2006**

**OR**

 

**o        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition period from                      to                     **

 

**Commission file number0-29911**

 

**THE SCO GROUP, INC.**

(Exactname of registrant as specified in its charter)

 

| **Delaware**                     | **87-0662823**                           |
|----------------------------------|------------------------------------------|
| (State  or other jurisdiction of | (I.R.S.  Employer Identification Number) |
| incorporation  or organization)  |                                     |

 

**355South 520 West**

**Suite100**

**Lindon,Utah 84042**

(Addressof principal executive offices and zip code)

 

**(801)765-4999**

(Registrant’stelephone 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 theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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 o

 

Indicate by check mark whether the registrantis a large accelerated filer, an accelerated filer, or a non-acceleratedfiler.  See definition of “acceleratedfiler” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (CheckOne):  Large Accelerated Filer oAcceleratedfiler oNon-accelerated Filer x

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).  (Check one):  YES o NO x

 

As of June 9, 2006, there were 21,090,757 shares of the Registrant’scommon stock, $0.001 par value per share, outstanding.

 

 

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**The SCO Group, Inc.**

 

**Table of Contents**

 

 
| PART I.  | FINANCIAL  INFORMATION                                                                                                             |   |
|----------|------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.  | Unaudited  Financial Statements                                                                                                    |   |
|     | Condensed  Consolidated Balance Sheets as of April 30, 2006 and October 31, 2005                                                   |   |
|     | Condensed Consolidated Statements of Operations and  Comprehensive Loss for the three and six months ended April 30, 2006 and 2005 |   |
|     | Condensed Consolidated Statements of Cash Flows for  the six months ended April 30, 2006 and 2005                                  |   |
|     | Notes to Condensed Consolidated Financial Statements                                                                               |   |
| Item  2. | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                        |   |
| Item 3.  | Quantitative and Qualitative Disclosures About Market  Risk                                                                        |   |
| Item 4.  | Controls and Procedures                                                                                                            |   |
| PART II. | OTHER  INFORMATION                                                                                                                 |   |
| Item 1.  | Legal  Proceedings                                                                                                                 |   |
| Item 1A. | Risk Factors                                                                                                                       |   |
| Item 4.  | Submission  of Matters to a Vote of Security Holders                                                                               |   |
| Item 6.  | Exhibits                                                                                                                           |   |
|     | Signatures                                                                                                                         |   |

 

2

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PART I.          FINANCIALINFORMATION

ITEM 1.          UNAUDITEDFINANCIAL STATEMENTS

 

 

**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(inthousands, except per share data)**

 

 
| ** **                                                                                                          | ** ** | **April 30,** | ** ** | **October 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|---------------|------------|-----------------|------------|
| ** **                                                                                                          | ** ** | **2006**      | ** ** | **2005**        | ** ** |
|                                                                                                                |       |          |       |            |       |
| **ASSETS**                                                                                                          | ** ** | ** **    | ** ** | ** **      | ** ** |
|                                                                                                                |       |          |       |            |       |
| CURRENT ASSETS:                                                                                                     |       |          |       |            |       |
| Cash and cash equivalents                                                                                           |       | $             | 9,524      |            | $          | 4,272 |   |
| Restricted cash                                                                                                     |       | 3,340         |       | 5,690           |       |
| Available-for-sale marketable securities                                                                            |       | 9,100         |       | 6,165           |       |
| Accounts receivable, net of allowance for doubtful accounts of  $119 and $144, respectively                    |       | 5,109         |       | 6,343           |       |
| Other                                                                                                               |       | 1,728         |       | 2,454           |       |
| Total current assets                                                                                                |       | 28,801        |       | 24,924          |       |
|                                                                                                                |       |          |       |            |       |
| PROPERTY AND EQUIPMENT:                                                                                             |       |          |       |            |       |
| Computer and office equipment                                                                                       |       | 2,110         |       | 2,224           |       |
| Leasehold improvements                                                                                              |       | 289           |       | 345             |       |
| Furniture and fixtures                                                                                              |       | 70            |       | 96              |       |
|                                                                                                                |       | 2,469         |       | 2,665           |       |
| Less accumulated depreciation and amortization                                                                      |       | (1,894        | )          | (2,087          | )          |
| Net property and equipment                                                                                          |       | 575           |       | 578             |       |
|                                                                                                                |       |          |       |            |       |
| OTHER ASSETS:                                                                                                       |       |          |       |            |       |
| Definite-lived intangibles, net                                                                                     |       | 1,353         |       | 2,707           |       |
| Other                                                                                                               |       | 732           |       | 739             |       |
| Total other assets                                                                                                  |       | 2,085         |       | 3,446           |       |
|                                                                                                                |       |          |       |            |       |
| Total assets                                                                                                        |       | $             | 31,461     |            | $          | 28,948 |   |
|                                                                                                                |       |          |       |            |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                      | ** ** | ** **    | ** ** | ** **      | ** ** |
|                                                                                                                |       |          |       |            |       |
| CURRENT LIABILITIES:                                                                                                |       |          |       |            |       |
| Accounts payable                                                                                                    |       | $             | 3,669      |            | $          | 2,197 |   |
| Payable to Novell, Inc.                                                                                             |       | 3,200         |       | 2,815           |       |
| Accrued payroll and benefits                                                                                        |       | 2,072         |       | 2,656           |       |
| Accrued liabilities                                                                                                 |       | 3,208         |       | 3,118           |       |
| Deferred revenue                                                                                                    |       | 3,383         |       | 3,841           |       |
| Royalties payable                                                                                                   |       | 281           |       | 406             |       |
| Income taxes payable                                                                                                |       | 1,295         |       | 1,222           |       |
| Total current liabilities                                                                                           |       | 17,108        |       | 16,255          |       |
|                                                                                                                |       |          |       |            |       |
| LONG-TERM LIABILITIES                                                                                               |       | 265           |       | 338             |       |
|                                                                                                                |       |          |       |            |       |
| COMMITMENTS AND CONTINGENCIES (Note 4)                                                                              |       |          |       |            |       |
|                                                                                                                |       |          |       |            |       |
| COMMON STOCK SUBJECT TO RESCISSION (Note 5)                                                                         |       | —        |       | 1,018           |       |
|                                                                                                                |       |          |       |            |       |
| STOCKHOLDERS’ EQUITY:                                                                                          |       |          |       |            |       |
| Common stock, $0.001 par value; 45,000 shares authorized,  21,299 and 18,331 shares outstanding,  respectively |       | 21            |       | 18              |       |
| Additional paid-in capital                                                                                          |       | 258,975       |       | 246,985         |       |
| Common stock held in treasury; 297 and 290 shares, respectively                                                     |       | (2,446        | )          | (2,414          | )          |
| Warrants outstanding                                                                                                |       | 856           |       | 856             |       |
| Accumulated other comprehensive income                                                                              |       | 899           |       | 834             |       |
| Accumulated deficit                                                                                                 |       | (244,217      | )          | (234,942        | )          |
| Total stockholders’ equity                                                                                     |       | 14,088        |       | 11,337          |       |
|                                                                                                                |       |          |       |            |       |
| Total liabilities and stockholders’ equity                                                                     |       | $             | 31,461     |            | $          | 28,948 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

3

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ANDCOMPREHENSIVE LOSS**

**(inthousands, except per share data)**

 
| ** **                                                   | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                   | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                   | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| REVENUE:                                                     |       |                             |       |                           |       |   |   |   |   |
| Products                                                     |       | $                                | 5,703      |                           | $          | 7,838 |   | $ | 11,703 |   | $ | 15,142 |   |
| SCOsource licensing                                          |       | 34                               |       | 30                             |       | 64 |   | 100 |   |
| Services                                                     |       | 1,389                            |       | 1,390                          |       | 2,702 |   | 2,881 |   |
| Total revenue                                                |       | 7,126                            |       | 9,258                          |       | 14,469 |   | 18,123 |   |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| COST OF REVENUE:                                             |       |                             |       |                           |       |   |   |   |   |
| Products                                                     |       | 497                              |       | 563                            |       | 1,081 |   | 1,207 |   |
| SCOsource licensing                                          |       | 3,762                            |       | 2,889                          |       | 7,772 |   | 6,382 |   |
| Services                                                     |       | 709                              |       | 746                            |       | 1,346 |   | 1,495 |   |
| Total cost of revenue                                        |       | 4,968                            |       | 4,198                          |       | 10,199 |   | 9,084 |   |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| GROSS MARGIN                                                 |       | 2,158                            |       | 5,060                          |       | 4,270 |   | 9,039 |   |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| OPERATING EXPENSES:                                          |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                                          |       | 2,857                            |       | 2,970                          |       | 5,545 |   | 5,914 |   |
| Research and development                                     |       | 1,886                            |       | 2,117                          |       | 3,757 |   | 4,205 |   |
| General and administrative                                   |       | 1,718                            |       | 2,036                          |       | 3,310 |   | 3,799 |   |
| Amortization of intangibles                                  |       | 593                              |       | 593                            |       | 1,185 |   | 1,186 |   |
| Total operating expenses                                     |       | 7,054                            |       | 7,716                          |       | 13,797 |   | 15,104 |   |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| LOSS FROM OPERATIONS                                         |       | (4,896                           | )          | (2,656                         | )          | (9,527 | ) | (6,065 | ) |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| EQUITY IN INCOME (LOSS) OF AFFILIATE                         |       | —                           |       | 17                             |       | (8 | ) | 70 |   |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| OTHER INCOME, NET:                                           |       |                             |       |                           |       |   |   |   |   |
| Interest income                                              |       | 199                              |       | 98                             |       | 351 |   | 135 |   |
| Other income, net                                            |       | 117                              |       | 702                            |       | 110 |   | 1,174 |   |
| Total other income, net                                      |       | 316                              |       | 800                            |       | 461 |   | 1,309 |   |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| LOSS BEFORE PROVISION FOR INCOME TAXES                       |       | (4,580                           | )          | (1,839                         | )          | (9,074 | ) | (4,686 | ) |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| PROVISION FOR INCOME TAXES                                   |       | (114                             | )          | (123                           | )          | (201 | ) | (237 | ) |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| NET LOSS                                                     |       | $                                | (4,694     | )                              | $          | (1,962 | ) | $ | (9,275 | ) | $ | (4,923 | ) |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| BASIC AND DILUTED NET LOSS PER COMMON SHARE                  |       | $                                | (0.22      | )                              | $          | (0.11 | ) | $ | (0.45 | ) | $ | (0.28 | ) |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| WEIGHTED AVERAGE BASIC AND DILUTED COMMON SHARES OUTSTANDING |       | 20,994                           |       | 17,913                         |       | 20,520 |   | 17,831 |   |
|                                                         |       |                             |       |                           |       |   |   |   |   |
| OTHER COMPREHENSIVE LOSS:                                    |       |                             |       |                           |       |   |   |   |   |
| Net loss                                                     |       | $                                | (4,694     | )                              | $          | (1,962 | ) | $ | (9,275 | ) | $ | (4,923 | ) |
| Unrealized gain on available-for-sale marketable securities  |       | 11                               |       | 12                             |       | 45 |   | 9 |   |
| Foreign currency translation adjustment                      |       | 26                               |       | (58                            | )          | 20 |   | 4 |   |
| COMPREHENSIVE LOSS                                           |       | $                                | (4,657     | )                              | $          | (2,008 | ) | $ | (9,210 | ) | $ | (4,910 | ) |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

4

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

 
| ** **                                                                                               | ** ** | **Six Months Ended April 30,** | ** **   |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------|--------------|
| ** **                                                                                               | ** ** | **2006**                       | ** **   | **2005** | ** ** |
|                                                                                                     |       |                           |         |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                    |       |                           |         |   |   |
| Net loss                                                                                                 |       | $                              |  (9,275 | ) | $ | (4,923 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities:                             |       |                           |         |   |   |
| Amortization of intangibles (including $169 and $167 classified as  cost of SCOsource licensing revenue) |       | 1,354                          |         | 1,353 |   |
| Depreciation and amortization                                                                            |       | 148                            |         | 184 |   |
| Stock-based compensation                                                                                 |       | 833                            |         | 22 |   |
| Loss on disposal of assets                                                                               |       | 7                              |         | 32 |   |
| Equity in (income) loss of affiliate                                                                     |       | 8                              |         | (70 | ) |
| Changes in operating assets and liabilities:                                                             |       |                           |         |   |   |
| Restricted cash                                                                                          |       | 2,735                          |         | 1,033 |   |
| Accounts receivable, net                                                                                 |       | 1,234                          |         | 313 |   |
| Other current assets                                                                                     |       | 726                            |         | (418 | ) |
| Other assets                                                                                             |       | (1                             | )            | 34 |   |
| Accounts payable                                                                                         |       | 1,472                          |         | (6,430 | ) |
| Accrued payroll and benefits                                                                             |       | (584                           | )            | (608 | ) |
| Compensation to law firms                                                                                |       | —                         |         | (7,956 | ) |
| Accrued liabilities                                                                                      |       | 90                             |         | (249 | ) |
| Deferred revenue                                                                                         |       | (458                           | )            | 19 |   |
| Royalties payable                                                                                        |       | (125                           | )            | (45 | ) |
| Income taxes payable                                                                                     |       | 73                             |         | 8 |   |
| Other long-term liabilities                                                                              |       | (73                            | )            | (1 | ) |
| Net cash used in operating activities                                                                    |       | (1,836                         | )            | (17,702 | ) |
|                                                                                                     |       |                           |         |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                    |       |                           |         |   |   |
| Purchase of property and equipment                                                                       |       | (153                           | )            | (145 | ) |
| Purchase of available-for-sale marketable securities                                                     |       | (6,435                         | )            | (8,200 | ) |
| Proceeds from sale of available-for-sale marketable securities                                           |       | 3,500                          |         | 20,909 |   |
| Net cash (used in) provided by investing activities                                                      |       | (3,088                         | )            | 12,564 |   |
|                                                                                                     |       |                           |         |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                    |       |                           |         |   |   |
| Proceeds from sale of common stock through employee stock purchase  plan                                 |       | 301                            |         | 373 |   |
| Proceeds from exercise of common stock options                                                           |       | 32                             |         | 205 |   |
| Repurchase of common stock                                                                               |       | (32                            | )            | — |   |
| Proceeds from sale of common stock in a private placement, net of  offering costs                        |       | 9,809                          |         | — |   |
| Net cash provided by financing activities                                                                |       | 10,110                         |         | 578 |   |
|                                                                                                     |       |                           |         |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                     |       | 5,186                          |         | (4,560 | ) |
| EFFECT OF FOREIGN EXCHANGE RATES ON CASH AND CASH EQUIVALENTS                                            |       | 66                             |         | 12 |   |
| CASH AND CASH EQUIVALENTS, beginning of period                                                           |       | 4,272                          |         | 12,693 |   |
| CASH AND CASH EQUIVALENTS, end of period                                                                 |       | $                              |  9,524  |   | $ | 8,145 |   |
|                                                                                                     |       |                           |         |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                                                        |       |                           |         |   |   |
|                                                                                                     |       |                           |         |   |   |
| Cash paid for income taxes                                                                               |       | $                              |  138    |   | $ | 248 |   |
|                                                                                                     |       |                           |         |   |   |
| SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES:                                                  |       |                           |         |   |   |
|                                                                                                     |       |                           |         |   |   |
| Increase (decrease) in common stock subject to rescission                                                |       | $                              |  (1,018 | ) | $ | 323 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

5

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**THE SCO GROUP, INC. AND SUBSIDIARIES**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

 

## **(1) ORGANIZATION AND DESCRIPTIONOF BUSINESS**

The business of The SCOGroup, Inc. (the “Company”, “we”, “us” or “our”) focuses on marketing reliable,cost-effective UNIX software products and related services for thesmall-to-medium sized business market, including replicated site franchises ofFortune 1000 companies.  The Company hasoperations in a number of countries that provide support services to customersand resellers. During the year ended October 31, 2003, the Company initiatedits SCOsource business to protect and defend its UNIX intellectualproperty.  The Company acquired certainintellectual property rights surrounding UNIX and UNIX System V source codefrom The Santa Cruz Operation, which changed its name to Tarantella, Inc., andwas subsequently acquired by Sun Microsystems, in May 2001.

In its efforts to protectand defend its intellectual property rights, the Company incurred a net loss of$9,275,000 for the six months ended April 30, 2006 and during that same period,the Company used cash of $1,836,000 in its operating activities.  As of April 30, 2006, the Company had a totalof $9,524,000 in cash and cash equivalents, $9,100,000 in available-for-salemarketable securities, and $3,340,000 in restricted cash, of which $140,000 isdesignated to pay for experts, consultants and other expenses in the SCOLitigation (as defined herein), and the remaining $3,200,000 of restricted cashis payable to Novell for its retained binary royalty stream.  On June 5, 2006, the Company entered into anamendment to the Engagement Agreement with Boies, Schiller &Flexner LLP, Kevin McBride and Berger Singerman (the “Law Firms”) andagreed to deposit an additional $5,000,000 into the escrow account to coverfuture expert, consulting and other expenses.

## **(2) SIGNIFICANT ACCOUNTING POLICIES**

### **Basisof Presentation**

The accompanying unaudited condensed consolidatedfinancial statements of the Company have been prepared by the Company pursuantto the rules and regulations of the Securities and Exchange Commission (“SEC”)on a basis consistent with the Company’s audited annual financial statements,and, in the opinion of management, reflect all adjustments, consisting only ofnormal recurring adjustments, necessary to present fairly the financialinformation set forth therein.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with U.S. generally accepted accounting principles havebeen condensed or omitted pursuant to SEC rules and regulations, although theCompany believes that the following disclosures, when read in conjunction withthe audited annual financial statements and the notes thereto included in theCompany’s most recent annual report on Form 10-K, are adequate to make theinformation presented not misleading. Operating results for the three and six months ended April 30, 2006 arenot necessarily indicative of the operating results that may be expected forthe year ending October 31, 2006.

### **Useof Estimates in the Preparation of Financial Statements**

The preparation of financial statements in conformitywith U.S. generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the

 

6

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dateof the financial statements and the reported amounts of revenue and expensesduring the reporting periods.  Actual resultscould differ from these estimates.  TheCompany’s critical accounting policies and estimates include, among others,revenue recognition, allowances for doubtful accounts receivable,  impairment and useful lives of long-livedassets, litigation reserves, and valuation allowances against deferred incometax assets.

### **RevenueRecognition**

The Company recognizes revenue in accordance withStatement of Position (“SOP”) 97-2, as modified by SOP 98-9.  The Company’s revenue has historically beenfrom three sources: (i) product license revenue, primarily from product salesto resellers, end users and original equipment manufacturers (“OEMs”); (ii)technical support service revenue, primarily from providing technical supportand consulting services to end users; and (iii) revenue from SCOsourcelicensing.

The Company recognizes product revenue upon shipmentif a signed contract exists, the fee is fixed or determinable, collection ofthe resulting receivable is probable and product returns are reasonablyestimable.

The majority of the Company’s revenue transactionsrelate to product-only sales.  Onoccasion, the Company has revenue transactions that have multiple elements(such as software products, maintenance, technical support services, and otherservices).  For software agreements thathave multiple elements, the Company allocates revenue to each component of thecontract based on the relative fair value of the elements.  The fair value of each element is based onvendor specific objective evidence (“VSOE”). VSOE is established when such elements are sold separately.  The Company recognizes revenue when thecriteria for product revenue recognition set forth above have been met.  If VSOE of all undelivered elements exists,but VSOE does not exist for one or more delivered elements, then revenue isrecognized using the residual method. Under the residual method, the fair value of the undelivered elements isdeferred and the remaining portion of the license fee is recognized as revenuein the period when persuasive evidence of an arrangement is obtained, assumingall other revenue recognition criteria are met.

The Company recognizes product revenue from OEMs whenthe software is sold by the OEM to an end-user customer.  Revenue from technical support services andconsulting services is recognized as the related services are performed.  Revenue for maintenance is recognized ratablyover the maintenance period.

The Company considers an arrangement with paymentterms longer than the Company’s normal business practice not to be fixed ordeterminable, and revenue is recognized when the fee becomes due.  The Company typically provides stock rotationrights for sales made through its distribution channel and sales todistributors are recognized upon shipment by the distributor to end users.  For direct sales not through the Company’sdistribution channel, sales are typically non-refundable andnon-cancelable.  The Company estimatesits product returns based on historical experience and maintains an allowancefor estimated returns, which is recorded as a reduction to accounts receivable.

The Company’s SCOsource revenue to date has beenprimarily generated from agreements to utilize the Company’s UNIX source codeas well as from intellectual property compliance agreements.  The Company recognizes revenue from SCOsourceagreements when a signed contract exists, the fee is fixed or determinable,collection of the receivable is probable and delivery has occurred.  If the payment terms extend beyond theCompany’s normal payment terms, revenue is recognized as the payments becomedue.

**Cash and Cash Equivalents**

7

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The Company considers all investments purchased withoriginal maturities of three months or less to be cash equivalents.  Cash equivalents were $5,816,000 and$1,528,000 as of April 30, 2006 and October 31, 2005, respectively.  Cash was $3,708,000 and $2,744,000 as ofApril 30, 2006 and October 31, 2005, respectively.

**Available-for-Sale Marketable Securities**

Available-for-sale marketable securities are recordedat fair market value, based on quoted market prices, and unrealized gains andlosses are recorded as a component of comprehensive loss.  Realized gains and losses, which arecalculated based on the specific-identification method, are recorded inoperations as incurred.

                Available-for-sale marketablesecurities totaled $9,100,000 as of April 30, 2006.  Any available-for-sale marketable securitiesin an unrealized loss position as of April 30, 2006 were not impaired atacquisition and the decline in fair value is primarily attributable to interestrate fluctuations.  A decline in themarket value of any available-for-sale marketable security below cost that isdeemed other than temporary results in a charge to earnings and establishes anew basis for the security.

**Net Loss per Common Share**

Basic net loss per common share (“Basic EPS”) iscomputed by dividing net loss by the weighted average number of common sharesoutstanding.  Diluted net income percommon share (“Diluted EPS”), if any, is computed by dividing net income by thesum of the weighted average number of common shares outstanding and thedilutive potential common share equivalents then outstanding.  Potential common share equivalents consist ofthe weighted average number of shares issuable upon the exercise of outstandingstock options and warrants to acquire common stock.  If dilutive, the Company computes Diluted EPSusing the treasury stock method.

The excluded anti-dilutive common share equivalents of4,981,000 and 3,696,000 for the three and six months ended April 30, 2006 and2005, respectively, are not included in the computation of Diluted EPS as theireffect would have decreased Diluted EPS.

**(3) DEFINITE-LIVED INTANGIBLE ASSETS**

The following table shows the activity related todefinite-lived intangible assets for the six months ended April 30, 2006 aswell as the remaining unamortized balances as of April 30, 2006 (in thousands):

| ** **                             | ** ** | **As of  October 31, 2005** | ** ** | **Six Months  Ended  April 30, 2006** | ** ** | **As of  April 30, 2006** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------|------------|
| ** **                             | ** ** | **Carrying Value**          | ** ** | **Amortization  Expense**             | ** ** | **Carrying Value**        | ** ** |
| Definite-lived intangible  assets:     |       |                        |       |                                  |       |                      |       |
| Distribution/reseller channel          |       | $                           | 2,318      |                                  | $          | (1,159                    | )          | $ | 1,159 |   |
| Acquired technology                    |       | 337                         |       | (169                                  | )          | 168                       |       |
| Trade name                             |       | 52                          |       | (26                                   | )          | 26                        |       |
| Total definite-lived intangible assets |       | $                           | 2,707      |                                  | $          | (1,354                    | )          | $ | 1,353 |   |

 

Of the $1,354,000 in amortization expense for the sixmonths ended April 30, 2006, $1,185,000 was classified as amortization ofintangible assets in operating expenses and the remaining $169,000 was classifiedas cost of SCOsource licensing revenue.

8

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**(4) COMMITMENTS AND CONTINGENCIES**

**Litigation**

*IBMCorporation*

Onor about March 6, 2003, the Company filed a civil complaint against IBM in theUnited States District Court for the District of Utah, under the title The SCOGroup, Inc. v. International Business Machines Corporation, Civil No.2:03CV0294.  In this action, the Companyclaims, among other things, that IBM breached its UNIX source code licenses(both the IBM and Sequent Computer Systems, Inc. “Sequent” licenses) bydisclosing restricted information concerning the UNIX source code andderivative works and related information in connection with its efforts topromote the Linux operating system.  TheCompany’s complaint includes, among other things, claims for breach ofcontract, unfair competition, tortious interference and copyrightinfringement.  As a result of IBM’sactions, the Company is requesting damages in an amount to be proven at trialand seeking injunctive relief.

Onor about March 6, 2003, the Company notified IBM that IBM was not in compliancewith the Company’s UNIX source code license agreement and on or about June 13,2003, the Company delivered to IBM a notice of termination of IBM’s UNIX sourcecode license agreement, which underlies IBM’s AIX software.  On or about August 11, 2003, the Company senta similar notice terminating the Sequent source code license.  IBM disputes the Company’s right to terminatethose licenses.  In the event the Company’stermination of those licenses is valid, the Company believes IBM is exposed tosubstantial damages and injunctive relief claims based on its continued use anddistribution of the AIX operating system. On June 9, 2003, Novell sent the Company a notice purporting to waivethe Company’s claims against IBM regarding its license breaches.  The Company does not believe that Novell hadthe right to take any such action relative to the Company’s UNIX source coderights.

                On February 27, 2004, theCompany filed a second amended complaint which alleges nine causes of actionthat are similar to those set forth above, adds a new claim for copyrightinfringement and removes the claim for misappropriation of trade secrets.  IBM filed an answer and fourteen counterclaims.  Among other things, IBM has asserted that theCompany does not have the right to terminate IBM’s UNIX license and IBM hasclaimed that the Company has breached the GNU General Public License and hasinfringed certain patents held by IBM. IBM’s counterclaims include claims for breach of contract, violation ofthe Lanham Act, unfair competition, intentional interference with prospectiveeconomic relations, unfair and deceptive trade practices, promissory estoppel,patent infringement and a declaratory judgment claim for non-infringement ofcopyrights.  On October 6, 2005, IBMvoluntarily dismissed with prejudice its claims for patent infringement.

OnFebruary 9, 2005, the court denied three motions for partial summaryjudgment that IBM had filed on the Company’s contract claims, on IBM’s eighthcounterclaim for copyright infringement, and on IBM’s tenth counterclaim for adeclaration of non-infringement of the Company’s copyrights.  The court denied each of those motionswithout prejudice to IBM’s renewing or refiling the motions after discovery iscomplete.  The court also denied theCompany’s motion to stay or dismiss IBM’s tenth counterclaim.  The court ordered that no further dispositivemotions could be filed until the close of discovery.

OnJuly 1, 2005, the court issued a revised Scheduling Order establishing,among other things, discovery and motion deadlines over the next 18 months witha five-week jury trial to commence on February 26, 2007.

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Pursuantto the court’s July 1, 2005 Scheduling Order, the Company filed its InterimDisclosure of Material Misused by IBM on October 28, 2005.  The Company’s report included a matrix thatidentifies 217 separate technology disclosures that it contends IBM improperlymade to enhance Linux in violation of one or more contractual prohibitionsgoverning IBM’s use of the Company’s proprietary material.  The Company continued to review relevantmaterials, including evidence IBM has produced in discovery, and filed anupdated report on December 22, 2005 detailing IBM’s misuse of the Company’sproprietary material.  The Company’sDecember 22, 2005 report included 294 total disclosures which the Companyclaims violate its contractual rights and copyrights.  These reports and the disclosures identifiedare the result of analysis from experienced outside technical consultants.

OnFebruary 13, 2006, IBM filed a motion with the court seeking to limit theCompany’s claims.  IBM argues that of the294 items identified by the Company in the December 22, 2005 filing, 201 didnot meet the level of specificity required by the court.  IBM requested that the Company be limited to93 items set forth in the December 22, 2005 filing which IBM claims meet therequired level of specificity.  TheCompany disagrees with IBM’s motion and analysis and filed an opposition briefunder seal with the court.  The courtheard arguments on the matter on April 14, 2006 and took the matter underadvisement.  On June 8, 2006, IBM filed amotion to confine the Company’s claims to, and strike allegations in excess of,the final disclosures.  In this motion,IBM claims that the Company’s technology expert reports go beyond thedisclosures contained in the Company’s December 22, 2005 submission to the courtand that those expert reports should be stricken to that extent.  Discovery is ongoing in the case as theparties prepare for trial.

*Novell, Inc.*

OnJanuary 20, 2004, the Company filed suit in Utah state court againstNovell, Inc. for slander of title seeking relief for its alleged bad faitheffort to interfere with the Company’s ownership of copyrights related to theCompany’s UNIX source code and derivative works and the Company’s UnixWareproduct.  The case is pending in theUnited States District Court for the District of Utah under the caption, TheSCO Group, Inc. v. Novell, Inc., Civil No. 2:04CV00139.  In the lawsuit, the Company requestedpreliminary and permanent injunctive relief as well as damages.  Through these claims, the Company seeks to requireNovell to assign to the Company all copyrights that the Company believes Novellhas wrongfully registered, prevent Novell from representing any ownershipinterest in those copyrights and require Novell to retract or withdraw allrepresentations it has made regarding its purported ownership of thosecopyrights and UNIX itself.

Novell has filedtwo motions to dismiss claiming, among other things, that Novell’s falsestatements were not uttered with malice and are privileged under the law.  The court denied both of Novell’s motions todismiss.  On July 29, 2005, Novell filedits answer and counterclaims against the Company, asserting counterclaims forthe Company’s alleged breaches of the Asset Purchase Agreement between Novelland the Company’s predecessor-in-interest, The Santa Cruz Operation, Inc., forslander of title, restitution/unjust enrichment, an accounting related toNovell’s retained binary royalty stream, and for declaratory relief regardingNovell’s alleged rights under the Asset Purchase Agreement.  On December 6, 2005, a scheduling order wasentered by the court setting a schedule of discovery and motions leading up toa trial in June 2007.  On or aboutDecember 30, 2005, the Company filed a motion for leave to amend its complaintto assert additional claims against Novell including copyright infringement,unfair competition and a breach of Novell’s limited license to use the Company’sUNIX code.  Novell has consented to theCompany’s filing of these additional claims.

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On or about April10, 2006, Novell filed a motion to stay the case in Utah pending a request forarbitration that Novell filed on the same date in the International Court ofArbitration in France.  Through theseproceedings, Novell claims that the Company granted Novell the right to use itsintellectual property through the Company’s participation in the United Linuxinitiative in 2002.  Through itsacquisition of SUSE Linux, GmbH, Novell claims it acquired all rights SUSE hadas a member of United Linux.  On May 26,2006, the Company filed a response to Novell’s motion to stay and the Companywill respond to Novell’s request for arbitration in due course.  No hearing on Novell’s motion has beenscheduled.  Discovery is commencing inthe case.

*AutoZone, Inc.*

Onor about March 2, 2004, the Company brought suit againstAutoZone, Inc. for its alleged violations of the Company’s UNIX copyrightsthrough its use of Linux.  The lawsuitalleges copyright infringement by AutoZone by, among other things, runningversions of the Linux operating system that contain proprietary material fromUNIX System V.  The lawsuit, filed inUnited States District Court in Nevada, requests injunctive relief against AutoZone’sfurther use or copying of any part of the Company’s copyrighted materials andalso requests damages as a result of AutoZone’s infringement in an amount to beproven at trial.  In response to AutoZone’smotion to transfer the case to Tennessee or stay the case, the federal court inNevada granted AutoZone’s motion to stay the case, with 90-day status reportsto the court, and denied without prejudice AutoZone’s motion to transfer thecase to Tennessee.  The court allowed theparties to take limited expedited discovery relating to the issue ofpreliminary injunctive relief which discovery was concluded in May 2005.

TheCompany concluded the initial discovery allowed by the court and filed itsreport with the court on May 27, 2005. Contrary to AutoZone’s own statements to the court, the Company foundthrough discovery, including depositions and other admissions of AutoZone, manyinstances of copying of programs containing the Company’s OpenServer code.  AutoZone has represented that it has nowremoved all of the Company’s code and proprietary information it copied or usedin its migration to Red Hat Linux. Because AutoZone represents it has removed or otherwise is not using theCompany’s code and proprietary information, the Company currently does notintend to move for a preliminary injunction. AutoZone does not admit that it violated the Company’s rights or causedit damage in that migration process, which are still points of dispute betweenthe parties.  Given the stay issued bythe court in the case, the Company reserves the right to pursue infringementand damages in the future based on these issues and other issues stayed by thecourt.

*IPOClass Action Matter*

TheCompany is an issuer defendant in a series of class action lawsuits involvingover 300 issuers that have been consolidated under In re Initial PublicOffering Securities Litigation, 21 MC 92 (SAS). The consolidated complaint alleges, among other things, certainimproprieties regarding the underwriters’ conduct during the Company’s initialpublic offering and the failure to disclose such conduct in the registrationstatement in violation of the Securities Act of 1933, as amended.

Theplaintiffs, the issuers and the insurance companies have negotiated anagreement to settle the dispute between the plaintiffs and the issuers.  All parties, including the plaintiffs,issuers and insurance companies, have executed this settlement agreement andthe settlement agreement has been submitted to the court for approval.  If the settlement agreement is approved bythe court, and if no cross-claims, counterclaims or third-party claims arelater asserted, this action will be dismissed with respect to the Company andits directors.

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TheCompany has notified its underwriters and insurance companies of the existenceof the claims.  Management believes,after consultation with legal counsel, that the ultimate outcome of this matterwill not have a material adverse effect on the Company’s results of operationsor financial position and will not exceed the $200,000 self-insured retentionalready paid or accrued by the Company.

*RedHat, Inc.*

OnAugust 4, 2003, Red Hat, Inc. filed a complaint against theCompany.  The action is pending in theUnited States District Court for the District of Delaware under the casecaption, Red Hat, Inc. v. The SCO Group, Inc., CivilNo. 03-772.  Red Hat asserts thatthe Linux operating system does not infringe on the Company’s UNIX intellectualproperty rights and seeks a declaratory judgment for non-infringement ofcopyrights and no misappropriation of trade secrets.  In addition, Red Hat claims the Company hasengaged in false advertising in violation of the Lanham Act, deceptive tradepractices, unfair competition, tortious interference with prospective businessopportunities, trade libel and disparagement. On April 6, 2004, the court denied the Company’s motion to dismissthis case; however, the court stayed the case and requested status reportsevery 90 days regarding the case against IBM.  Red Hat filed a motion for reconsideration,which the court denied on March 31, 2005. The Company intends to vigorously defend this action.  In the event the stay is lifted and Red Hatis allowed to pursue its claims, the Company will likely assert counterclaimsagainst Red Hat.

*Other Matters*

InApril 2003, the Company’s former Indian distributor filed a claim inIndia, requesting summary judgment for payment of approximately $1,428,000, andan order that the Company trade in India only through the distributor and/orgive a security deposit until the claim is paid.  The distributor claims that the Company isresponsible to repurchase certain software products and to reimburse thedistributor for certain other operating costs. Management does not believe that the Company is responsible to reimbursethe distributor for any operating costs and also believes that the returnrights related to any remaining inventory have lapsed.  The distributor additionally requested thatthe Indian courts grant interim relief in the form of attachment of localassets.  These requests for interimrelief have failed in the court, and discovery has commenced and hearings onthe main claims have been held and are ongoing. The Company intends to vigorously defend this action.

Pursuit and defense of theabove-mentioned matters will be costly, and management expects the costs forlegal fees and related expenses will be substantial.

The ultimate outcome orpotential negative effect on the Company’s results of operations or financialposition of the Red Hat, Inc., IPO Class Action, Indian Distributor matter, orIBM or Novell counterclaims is neither probable nor estimable.

The Company is a party to certain other legalproceedings arising in the ordinary course of business.  Management believes, after consultation withlegal counsel, that the ultimate outcome of these legal proceedings will nothave a material adverse effect on the Company’s results of operations orfinancial position.

**(5)COMMON STOCK SUBJECT TO RESCISSION**

The Company believes certain shares and optionsgranted under its Equity Compensation Plans were issued without complying withregistration or qualification requirements under federal securities laws andthe securities laws of certain states. As a result, certain Plan participants had a right to rescind theirpurchases of shares under the Plans or recover damages if they no longer ownthe shares or hold unexercised options, subject to

12

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applicablestatutes of limitations.  Additionally,regulatory authorities may require the Company to pay fines or impose othersanctions.

Accounting Series Release (“ASR”) No. 268 and EmergingIssues Task Force (“EITF”) Topic D-98 require that stock subject to rescissionor redemption requirements outside the control of the Company to be classifiedoutside of permanent equity.  The exercise of the rescission right is atthe holders’ discretion, but exercise of that right may depend in part on thefair value of the Company’s common stock, which is outside of the Company’s andthe holders’ control. Consequently, common stock subject to rescission is classified astemporary equity.

In December 2005, theCompany offered to rescind a total of 337,289 shares of common stock issuedunder its 2000 Employee Stock Purchase Plan (the “ESPP”) to current and formeremployees while they resided in any of California, Connecticut, Illinois, NewJersey, Utah, Texas or Washington.  Theseshares represented all of the ESPP shares the Company issued to residents ofthese states for which a purchaser could claim a rescission right.  The rescission offer was intended to addressthe Company’s rescission liability relating to its federal and state securitieslaws compliance issues by allowing the holders of the shares covered by therescission offer to rescind the underlying securities transactions and sellthose securities back to the Company or recover damages, as the case may be.

The rescission offerconcluded on January 20, 2006.  As ofthat date, 14 offerees accepted the Company’s offer to rescind the purchase ofapproximately 7,300 shares.  The Companymade aggregate payments to such offerees of approximately $41,500, whichincluded approximately $31,800 for the purchase of the shares and approximately$9,700 in statutory interest and damages.  As a result of the rescission offer, theCompany believes it has extinguished its state rescission liability andmitigated its federal rescission liability to anyone to whom the rescissionoffer was made for noncompliance with the registration or qualificationrequirements of federal and state securities laws as they relate to the sharesissued under the ESPP.  Upon the close ofthe rescission offer, the Company reclassified the remainder of the commonstock subject to rescission which totaled $1,018,000 as additional paid-incapital in permanent equity.

**(6) STOCKHOLDERS’ EQUITY**

**Issuance of Common Stock**

On November 29, 2005, the Company entered into aCommon Stock Purchase Agreement (“Purchase Agreement”) with severalinstitutional investors and one member of the Company’s board ofdirectors.  On November 30, 2005, theCompany sold to the investors approximately 2,852,000 shares of the Company’scommon stock for gross proceeds of approximately $10,005,000.  Through April 30, 2006, the costs tofacilitate the private placement of the common stock were approximately$196,000.  The shares issued to theinstitutional investors were issued at $3.50 per share and the shares issued tothe board member were issued at $3.92 per share.  Pursuant to the Purchase Agreement, theCompany agreed to use its best efforts to file a registration statement withthe SEC covering the resale of this common stock, and to use its commerciallyreasonable efforts to have such registration statement declared effective.   On December 22, 2005, the Company filed aregistration statement with the Securities and Exchange Commission.  On March 1, 2006, the Company filedpre-effective amendment number one to this registration statement, and on May2, 2006, the Company filed pre-effective amendment number two to thisregistration statement.  On May 25, 2006,this registration statement was declared effective by the SEC.

**Equity Plans**

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TheCompany has established the 1998 Stock Option Plan (the “1998 Plan”), 1999Omnibus Stock Incentive Plan (the “1999 Plan”), the 2002 Omnibus StockIncentive Plan (the “2002 Plan”) and the 2004 Omnibus Stock Incentive Plan (the“2004 Plan”) for the award of stock options, stock appreciation rights,restricted stock, phantom stock rights, and stock bonuses to employees,executive officers, members of the Board of Directors and outsideconsultants.  The Compensation Committeeof the Board of Directors has the ability to determine the terms of the option,the exercise price, the number of shares subject to each option, and theexercisability of the options.  Under theterms of the 1998, 1999, 2002 and 2004 Plans, options generally expire 10 yearsfrom the date of grant or within 90 days of termination.  Options granted under these plans generallyvest at 25 percent after the completion of one year of service and then 1/36per month for the remaining three years and are fully vested at the end of fouryears.   Pursuant to the terms of theirgrant agreements, certain of the options granted under these plans may besubject to accelerated vesting upon a change in control of the Company.

The Company has also established the ESPP, which isdesigned to allow eligible employees of the Company and its participatingsubsidiaries to purchase shares of the Company’s common stock, at semi-annualintervals, through periodic payroll deductions.

Prior to October 31, 2005, as permitted underStatement of Financial Accounting Standards (“SFAS”) No. 123, the Companyaccounted for its stock option plans following the recognition and measurementprinciples of Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor Stock issued to Employees,” and related interpretations.  Accordingly, no stock-based compensationexpense had been reflected in the Company’s statements of operations as alloptions granted had an exercise price equal to the market value of theunderlying common stock on the date of grant and the related number of sharesgranted was fixed at that point in time.

In December 2004, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 123(R), “Share Based Payment.”  This statement revised SFAS No. 123 byeliminating the option to account for employee stock options under APB No. 25and requires companies to recognize the cost of employee services received inexchange for awards of equity instruments based on the grant-date fair value ofthose awards.

Effective November 1, 2005, the Company adopted thefair value recognition provisions of SFAS No. 123(R) using the modifiedprospective application method.  Underthis transition method, the Company recorded compensation expense on astraight-line basis for the three and six months ended April 30, 2006, for: (a)the vesting of options granted prior to November 1, 2005 (based on thegrant-date fair value estimated in accordance with the original provisions ofSFAS No. 123, and previously presented in the pro-forma footnote disclosures),and (b) stock-based awards granted subsequent to November 1, 2005 (based on thegrant-date fair value estimated in accordance with the provisions of SFAS No.123(R)).  In accordance with the modifiedprospective application method, results for the three and six months endedApril 30, 2005 have not been restated.

The effect of accounting for stock-based awards underSFAS No. 123(R) for the three and six months ended April 30, 2006 was to record$432,000 and $833,000, respectively, of stock-based compensation expense.  For the three and six monthsended April 30, 2006 and 2005, the Company has allocated stock-basedcompensation expense to the following statement of operations and comprehensiveloss captions:

| ** **                             | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                   |       |                             |       |                           |       |   |   |   |   |
| Cost of products                       |       | $                                | 5,000      |                           | $          | — |   | $ | 7,000 |   | $ | — |   |
| Cost of SCOsource  licensing           |       | 57,000                           |       | —                         |       | 110,000 |   | — |   |
| Cost of services                       |       | 16,000                           |       | —                         |       | 29,000 |   | — |   |
| Sales and marketing                    |       | 91,000                           |       | 7,000                          |       | 159,000 |   | 14,000 |   |
| Research and development               |       | 36,000                           |       | —                         |       | 56,000 |   | 8,000 |   |
| General and administrative             |       | 227,000                          |       | —                         |       | 472,000 |   | — |   |
| Total stock-based compensation expense |       | $                                | 432,000    |                           | $          | 7,000 |   | $ | 833,000 |   | $ | 22,000 |   |

 

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The following pro-forma information, as required bySFAS No. 148, “Accounting for Stock-Based Compensation-Transition andDisclosure, an amendment of FASB Statement No. 123,” is presented forcomparative purposes and illustrates the effect on net loss and net loss percommon share for the three and six months ended April 30, 2005 as if the Companyhad applied the fair value recognition provisions of SFAS No. 123 tostock-based employee compensation prior to November 1, 2005 (in thousands):

| ** **                                             | ** ** | **Three Months Ended  April 30, 2005** | ** ** | **Six Months Ended  April 30, 2005** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| Net loss:                                              |       |                                   |       |                                 |       |
| As reported                                            |       | $                                      | (1,962     | )                                    | $          | (4,923 | ) |
| Stock-based compensation included in reported net loss |       | 7                                      |       | 22                                   |       |
| Stock-based compensation under fair value method       |       | (403                                   | )          | (597                                 | )          |
| Pro forma net loss                                     |       | $                                      | (2,358     | )                                    | $          | (5,498 | ) |
| Net loss per basic and  diluted common share:          |       |                                   |       |                                 |       |
| As reported                                            |       | $                                      | (0.11      | )                                    | $          | (0.28 | ) |
| Pro forma                                              |       | $                                      | (0.13      | )                                    | $          | (0.31 | ) |

 

With respect to stock optionsgranted during the three and six months ended April 30, 2006 and 2005, theassumptions used in the Black-Scholes option-pricing model are as follows:  

| ** **                         | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Risk-free interest rate            |       | 4.9                              | %          | 3.7                            | %          | 4.7 | % | 3.6 | % |
| Expected dividend yield            |       | 0.0                              | %          | 0.0                            | %          | 0.0 | % | 0.0 | % |
| Volatility                         |       | 61.1                             | %          | 51.5                           | %          | 62.1 | % | 72.4 | % |
| Expected exercise life (in  years) |       | 5.0                              |       | 2.7                            |       | 5.0 |   | 2.7 |   |

 

The estimated fair value ofstock options and ESPP shares are amortized over the vesting period of theaward.

During the six months ended April 30, 2006, theCompany granted options to purchase approximately 962,000 shares of commonstock with an average exercise price of $3.92 per share.  None of these stock options were granted withan exercise price below the quoted market price on the date of grant.  During the six months ended April 30, 2006,options to purchase approximately 27,000 shares of common stock were exercisedwith an average exercise price of $1.20 per share.  As of April 30, 2006, there wereapproximately 4,746,000 stock options outstanding with a weighted averageexercise price of $4.13 per share.

**(7)CONCENTRATION OF CREDIT RISK**

As of April 30, 2006 and October 31, 2005, the Company had no customerswho made up more than 10 percent of the accounts receivable balance.

During the three and six months ended April 30, 2006and 2005, no single customer accounted for more than 10 percent of totalrevenue.

**(8) SEGMENT INFORMATION**

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The Company’s resources are allocated and operatingresults managed to the operating income (loss) level for each of the Company’ssegments: UNIX and SCOsource.  Bothsegments are based on the Company’s UNIX intellectual property.  The UNIX business sells and distributes UNIXproducts and services through an extensive distribution channel and tocorporate end-users and the SCOsource business enforces and protects theCompany’s UNIX intellectual property. Segment disclosures for the Company are as follows (in thousands):

| ** **                   | ** ** | **Three Months Ended April 30, 2006** | ** ** |
|------------------------------|------------|---------------------------------------|------------|
| ** **                   | ** ** | **UNIX**                              | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                         |       |                                  |       |   |   |   |   |
| Revenue                      |       | $                                     | 7,092      |   | $ | 34 |   | $ | 7,126 |   |
| Cost of revenue              |       | 1,206                                 |       | 3,762 |   | 4,968 |   |
| Gross margin (deficit)       |       | 5,886                                 |       | (3,728 | ) | 2,158 |   |
| Sales and marketing          |       | 2,856                                 |       | 1 |   | 2,857 |   |
| Research and development     |       | 1,792                                 |       | 94 |   | 1,886 |   |
| General and administrative   |       | 1,681                                 |       | 37 |   | 1,718 |   |
| Amortization of  intangibles |       | 593                                   |       | — |   | 593 |   |
| Total operating expenses     |       | 6,922                                 |       | 132 |   | 7,054 |   |
| Loss from operations         |       | $                                     | (1,036     | ) | $ | (3,860 | ) | $ | (4,896 | ) |

 

| ** **                    | ** ** | **Three Months Ended April 30, 2005** | ** ** |
|-------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | **UNIX**                              | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                          |       |                                  |       |   |   |   |   |
| Revenue                       |       | $                                     | 9,228      |   | $ | 30 |   | $ | 9,258 |   |
| Cost of revenue               |       | 1,309                                 |       | 2,889 |   | 4,198 |   |
| Gross margin (deficit)        |       | 7,919                                 |       | (2,859 | ) | 5,060 |   |
| Sales and marketing           |       | 2,963                                 |       | 7 |   | 2,970 |   |
| Research and development      |       | 2,027                                 |       | 90 |   | 2,117 |   |
| General and administrative    |       | 1,866                                 |       | 170 |   | 2,036 |   |
| Amortization of  intangibles  |       | 593                                   |       | — |   | 593 |   |
| Total operating expenses      |       | 7,449                                 |       | 267 |   | 7,716 |   |
| Income (loss) from operations |       | $                                     | 470        |   | $ | (3,126 | ) | $ | (2,656 | ) |

 

| ** **                   | ** ** | **Six Months Ended April 30, 2006** | ** ** |
|------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **UNIX**                            | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                         |       |                                |       |   |   |   |   |
| Revenue                      |       | $                                   | 14,405     |   | $ | 64 |   | $ | 14,469 |   |
| Cost of revenue              |       | 2,427                               |       | 7,772 |   | 10,199 |   |
| Gross margin (deficit)       |       | 11,978                              |       | (7,708 | ) | 4,270 |   |
| Sales and marketing          |       | 5,544                               |       | 1 |   | 5,545 |   |
| Research and development     |       | 3,569                               |       | 188 |   | 3,757 |   |
| General and administrative   |       | 3,213                               |       | 97 |   | 3,310 |   |
| Amortization of  intangibles |       | 1,185                               |       | — |   | 1,185 |   |
| Total operating expenses     |       | 13,511                              |       | 286 |   | 13,797 |   |
| Loss from operations         |       | $                                   | (1,533     | ) | $ | (7,994 | ) | $ | (9,527 | ) |

 

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| ** **                    | ** ** | **Six Months Ended April 30, 2005** | ** ** |
|-------------------------------|------------|-------------------------------------|------------|
| ** **                    | ** ** | **UNIX**                            | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                          |       |                                |       |   |   |   |   |
| Revenue                       |       | $                                   | 18,023     |   | $ | 100 |   | $ | 18,123 |   |
| Cost of revenue               |       | 2,702                               |       | 6,382 |   | 9,084 |   |
| Gross margin (deficit)        |       | 15,321                              |       | (6,282 | ) | 9,039 |   |
| Sales and marketing           |       | 5,760                               |       | 154 |   | 5,914 |   |
| Research and development      |       | 4,003                               |       | 202 |   | 4,205 |   |
| General and administrative    |       | 3,538                               |       | 261 |   | 3,799 |   |
| Amortization of intangibles   |       | 1,186                               |       | — |   | 1,186 |   |
| Total operating expenses      |       | 14,487                              |       | 617 |   | 15,104 |   |
| Income (loss) from operations |       | $                                   | 834        |   | $ | (6,899 | ) | $ | (6,065 | ) |

 

Intangible assets, which consist of the Company’sreseller channel, trade name and technology, have been assigned to the Company’sUNIX and SCOsource segments and consist of the following as of April 30, 2006and October 31, 2005 (in thousands): 

| ** **                             | ** ** | **April 30,  2006** | ** ** | **October 31,  2005** | ** ** |
|----------------------------------------|------------|---------------------|------------|-----------------------|------------|
| Intangible assets:                     |       |                |       |                  |       |
| UNIX (reseller channel and trade name) |       | $                   | 1,185      |                  | $          | 2,370 |   |
| SCOsource (UNIX technology)            |       | 168                 |       | 337                   |       |
| Total intangible assets                |       | $                   | 1,353      |                  | $          | 2,707 |   |

 

17

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**ITEM 2.****                                                    ****MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

*ThisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations and other parts of this quarterly report on Form 10-Q containforward-looking statements that involve risks and uncertainties.  Forward-looking statements can also beidentified by words such as “intends,” “anticipates,” “expects,” “believes,” “plans,”“predicts,” and similar terms. Forward-looking statements are not guarantees of future performance andour actual results may differ significantly from the results discussed in theforward-looking statements.  Factors thatmight cause such differences include, but are not limited to, those set forthbelow under “Forward-Looking Statements and Factors that May Affect FutureResults and Financial Condition” and Item 1A — Risk Factors and elsewhere inthis Form 10-Q. The following discussion should be read in conjunction with ourunaudited condensed consolidated financial statements and notes theretoincluded in this Form 10-Q and our audited consolidated financial statementsincluded in our annual report on Form 10-K for the year ended October 31, 2005filed with the Securities and Exchange Commission and management’s discussionand analysis contained therein.  Allinformation presented herein is based on the three and six months ended April30, 2006.  We assume no obligation torevise or update any forward-looking statements for any reason, except asrequired by law.*

 

**Overview**

*Historical Background. *We originally incorporated as Caldera Systems, Inc., aUtah corporation (“Caldera Systems”), on August 21, 1998, and reincorporated asa Delaware corporation on March 6, 2000. In March 2000, we completed an initial public offering of our commonstock.  On May 7, 2001, we formed anew holding company in Delaware under the name of Caldera International, Inc. (“CalderaInternational”) to acquire substantially all of the assets and operations ofthe server and professional services groups of The Santa Cruz Operation.  In connection with this acquisition, CalderaSystems became a wholly owned subsidiary of Caldera International.  Former holders of shares and options to purchaseshares of Caldera Systems received an equal number of shares and options topurchase shares in Caldera International.  On May 16, 2003, our stockholders approvedour corporate name change to The SCO Group, Inc.

**Business Focus**

*UNIX Business. *Our UNIX business serves the needs of small-to-medium sized businesses,including replicated site franchisees of Fortune 1000 companies, by providingreliable, cost effective UNIX operating systems and software products to powercomputers running on Intel architecture. Our largest source of UNIX business revenue is derived from existingcustomers through our worldwide, indirect, leveraged channel of partners whichincludes distributors and independent solution providers.  We have operations in a number of countriesthat provide support and services to customers and resellers.  The other principal channel for selling andmarketing our UNIX products is through existing customers that have a largenumber of replicated sites or franchisees.

We access these corporationsthrough their information technology or purchasing departments with our areasales managers in the United States and through our reseller channel incountries outside the United States.  Inaddition, we also sell our operating system products to original equipmentmanufacturers (“OEMs”).  Our sales ofUNIX products and services during the last several fiscal years have beenprimarily to pre-existing UNIX customers and not newly acquired customers.  Our UNIX business revenue dependssignificantly on our ability to market and sell our products to existingcustomers and to generate upgrades from existing customers.

18

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The following table shows theoperating results of the UNIX business for the three and six months ended April30, 2006 and 2005 (in thousands):

| ** **                    | ** ** | **Three Months Ended April 30,** | ** ** |
|-------------------------------|------------|----------------------------------|------------|
| ** **                    | ** ** | **2006**                         | ** ** | **2005** | ** ** |
|                          |       |                             |       |   |   |
| Revenue                       |       | $                                | 7,092      |   | $ | 9,228 |   |
| Cost of revenue               |       | 1,206                            |       | 1,309 |   |
| Gross margin                  |       | 5,886                            |       | 7,919 |   |
| Sales and marketing           |       | 2,856                            |       | 2,963 |   |
| Research and development      |       | 1,792                            |       | 2,027 |   |
| General and administrative    |       | 1,681                            |       | 1,866 |   |
| Amortization of  intangibles  |       | 593                              |       | 593 |   |
| Total operating expenses      |       | 6,922                            |       | 7,449 |   |
| Income (loss) from operations |       | $                                | (1,036     | ) | $ | 470 |   |

 

| ** **                    | ** ** | **Six Months Ended April 30,** | ** ** |
|-------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **2006**                       | ** ** | **2005** | ** ** |
|                          |       |                           |       |   |   |
| Revenue                       |       | $                              | 14,405     |   | $ | 18,023 |   |
| Cost of revenue               |       | 2,427                          |       | 2,702 |   |
| Gross margin                  |       | 11,978                         |       | 15,321 |   |
| Sales and marketing           |       | 5,544                          |       | 5,760 |   |
| Research and development      |       | 3,569                          |       | 4,003 |   |
| General and administrative    |       | 3,213                          |       | 3,538 |   |
| Amortization of  intangibles  |       | 1,185                          |       | 1,186 |   |
| Total operating expenses      |       | 13,511                         |       | 14,487 |   |
| Income (loss) from operations |       | $                              | (1,533     | ) | $ | 834 |   |

 

Revenuefrom our UNIX business decreased by $2,136,000, or 23%, for the three monthsended April 30, 2006 compared to the three months ended April 30, 2005 anddecreased by $3,618,000, or 20%, for the six months ended April 30, 2006compared to the six months ended April 30, 2005.  The revenue from this business has beendeclining over the last several periods primarily as a result of increasedcompetition from alternative operating systems, particularly Linux.  We believe the inclusion of our UNIX code andderivative works in Linux has been a contributor to the decline in our UNIXbusiness because users of Linux generally do not pay for the operating systemitself, but pay for services and maintenance. The Linux operating system competes directly with our OpenServer andUnixWare products and has taken significant market share from these products.

In an effort to try toachieve and sustain profitability and generate positive cash flow from our UNIXbusiness, we have decreased our operating costs.  Operating costs for our UNIX businessdecreased from $7,449,000 for the three months ended April 30, 2005 to$6,922,000 for the three months ended April 30, 2006 and decreased from$14,487,000 for the six months ended April 30, 2005 to $13,511,000 for the sixmonths ended April 30, 2006.  These costreductions have primarily been attributable to operational efficienciesgenerated in our UNIX business as well as from the consolidation of certainfacilities, offset by an increase in stock-based compensation as a result ofthe adoption of SFAS No. 123(R) for the three and six months ended April 30,2006.

19

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In our UNIX business, we havereduced the number of full-time equivalent employees from 164 as of April 30,2005 to 162 as of April 30, 2006.  Wehave taken these headcount reductions and reduced other discretionary spendingwhile still maintaining a worldwide presence.

The decline in our UNIXbusiness revenue may be accelerated if industry partners withdraw their supportfor our products.  The decline in ourUNIX business and our SCOsource business may cause industry partners, developersand hardware and software vendors to choose not to support or certify to ourUNIX operating system products.  Thiswould lead to an accelerated decline in revenue and, potentially, negative cashflow from our UNIX business.

*SCOsource Business. *During the year ended October31, 2003, we became aware that our UNIX code and derivative works had beeninappropriately included by others in the Linux operating system.  We believe the inclusion of our UNIX code andderivative works in Linux has been a contributor to the decline in our UNIXbusiness because users of Linux generally do not pay for the operating systemitself, but pay for services and maintenance. The Linux operating system competes directly with our OpenServer andUnixWare products and has taken significant market share from these products.

In an effort to protect anddefend our UNIX intellectual property, we initiated our SCOsource business.  Our SCOsource revenue for the years endedOctober 31, 2005 and 2004 was significantly lower than revenue generated duringthe year ended October 31, 2003, and we believe and allege our revenue andrelated revenue opportunities have been adversely impacted by Novell’s claim ofUNIX copyright ownership, which may have caused potential customers to delay orforego licensing with us until an outcome in this legal matter has beenreached.

The following table shows theoperating results of the SCOsource business for the three and six months endedApril 30, 2006 and 2005 (in thousands):

| *** ***               | *** *** | **Three Months Ended April 30,** | *** *** |
|----------------------------|--------------|----------------------------------|--------------|
| *** ***               | *** *** | **2006**                         | ** **   | **2005** | *** *** |
|                       |         |                             |         |   |   |
| Revenue                    |         | $                                | 34           |   | $ | 30 |   |
| Cost of revenue            |         | 3,762                            |         | 2,889 |   |
| Gross deficit              |         | (3,728                           | )            | (2,859 | ) |
| Sales and marketing        |         | 1                                |         | 7 |   |
| Research and development   |         | 94                               |         | 90 |   |
| General and administrative |         | 37                               |         | 170 |   |
| Total operating expenses   |         | 132                              |         | 267 |   |
| Loss from operations       |         | $                                | (3,860       | ) | $ | (3,126 | ) |

 

| *** ***               | *** *** | **Six Months Ended April 30,** | *** *** |
|----------------------------|--------------|--------------------------------|--------------|
| *** ***               | *** *** | **2006**                       | ** **   | **2005** | *** *** |
|                       |         |                           |         |   |   |
| Revenue                    |         | $                              | 64           |   | $ | 100 |   |
| Cost of revenue            |         | 7,772                          |         | 6,382 |   |
| Gross deficit              |         | (7,708                         | )            | (6,282 | ) |
| Sales and marketing        |         | 1                              |         | 154 |   |
| Research and development   |         | 188                            |         | 202 |   |
| General and administrative |         | 97                             |         | 261 |   |
| Total operating expenses   |         | 286                            |         | 617 |   |
| Loss from operations       |         | $                              | (7,994       | ) | $ | (6,899 | ) |

 

20

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Revenue from our SCOsourcebusiness increased slightly from $30,000 for the three months ended April 30,2005 to $34,000 for the three months ended April 30, 2006 and decreased from$100,000 for the six months ended April 30, 2005 to $64,000 for the six monthsended April 30, 2006.  Revenue in theabove mentioned periods was primarily attributable to sales of our SCOsource IPagreements.

Cost of revenue, whichprimarily includes legal and professional fees incurred in connection with theSCO Litigation, increased from $2,889,000 for the three months ended April 30,2005 to $3,762,000 for the three months ended April 30, 2006 and increased from$6,382,000 for the six months ended April 30, 2005 to $7,772,000 for the sixmonths ended April 30, 2006.  Theseincreases were primarily attributable to significant work performed bytechnical, damage and industry experts and other consultants in connection withthe SCO Litigation.  Because of the unique and unpredictablenature of the SCO Litigation, the occurrence and timing of certain expensessuch as damage, industry and technical review and other consultants isdifficult to predict, and it will be difficult to predict the total cost ofrevenue for the upcoming quarters.

Because of the uncertainties related to our SCOsourcebusiness, we are unable to estimate the amount and timing of future SCOsourcelicensing revenue.  We are unlikely togenerate significant revenue from our SCOsource business unless and until weprevail in our SCO Litigation. Additionally, the success of the SCOsource business may depend on thestrength of our intellectual property rights and claims regarding UNIX,including our claims against Novell and the strength of our claim thatunauthorized UNIX source code and derivative works are contained in Linux.

**Critical Accounting Policies**

Our critical accounting policies and estimatesinclude the following:

•                              Revenuerecognition;

•                              Deferred incometax assets and related valuation allowances;

•                              Litigationreserves;

•                              Impairment and useful livesof long-lived assets; and

•                              Allowances fordoubtful accounts receivable.

*Revenue Recognition*. We recognize revenue in accordance with Statement of Position (“SOP”)97-2, as modified by SOP 98-9.  Ourrevenue has historically been from three sources: (i) product license revenue,primarily from product sales to resellers, end users and OEMs; (ii) technicalsupport service revenue, primarily from providing technical support andconsulting services to end users; and (iii) revenue from SCOsource licensing.

We recognize product revenue upon shipment if a signedcontract exists, the fee is fixed or determinable, collection of the resultingreceivable is probable and product returns are reasonably estimable.

The majority of our revenue transactions relate toproduct-only sales.  On occasion, we haverevenue transactions that have multiple elements (such as software products,maintenance, technical support services, and other services).  For software agreements that have multipleelements, we allocate revenue to each component of the contract based on therelative fair value of the elements.  Thefair value of each element is based on vendor specific objective evidence (“VSOE”).  VSOE is established when such elements aresold separately.  We recognize revenuewhen the criteria for product revenue recognition set forth above have beenmet.  If VSOE of all undelivered elementsexists, but VSOE does not exist for one or more delivered elements, thenrevenue is recognized using the residual method.  Under the residual method, the fair value of 

 

21

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theundelivered elements is deferred and the remaining portion of the license feeis recognized as revenue in the period when persuasive evidence of anarrangement is obtained assuming all other revenue recognition criteria aremet.

We recognize product revenue from OEMs when thesoftware is sold by the OEM to an end-user customer.  Revenue from technical support services andconsulting services is recognized as the related services are performed.  Revenue for maintenance is recognized ratablyover the maintenance period.

We consider an arrangement with payment terms longerthan our normal business practice, not to be fixed or determinable and revenueis recognized when the fee becomes due. We typically provide stock rotation rights for sales made through ourdistribution channel and sales to distributors are recognized upon shipment bythe distributor to end users.  For directsales not through our distribution channel, sales are typically non-refundableand non-cancelable.  We estimate ourproduct returns based on historical experience and maintain an allowance forestimated returns, which is recorded as a reduction to accounts receivable.

Our SCOsource revenue to date has been primarilygenerated from agreements to utilize our UNIX source code as well as from intellectualproperty compliance agreements.  Werecognize revenue from SCOsource agreements when a signed contract exists, thefee is fixed or determinable, collection of the receivable is probable anddelivery has occurred.  If the paymentterms extend beyond our normal payment terms, revenue is recognized as thepayments become due.

*Deferred Income Tax Assets andRelated Valuation Allowance*.  The amount,and ultimate realization, of our deferred income tax assets depends, in part,upon the tax laws in effect, our future earnings, if any, and other futureevents, the effects of which cannot be determined.  We have provided a valuation allowance of$69,239,000 against our entire net deferred income tax assets as of October 31,2005.  The valuation allowance wasrecorded because of our history of net operating losses and the uncertaintiesregarding our future operating profitability and taxable income.

*Litigation Reserves. *We are party to a number of legalmatters described in more detail elsewhere in this quarterly report on Form10-Q.  Pursuit and defense of these matters will be costly,and management expects the costs for legal fees and related expenses will besubstantial.  The ultimate outcome orpotential negative effect on our results of operations or financial position ofthe Red Hat, Inc., IPO Class Action, Indian Distributor matters, or the IBM andNovell counterclaims is neither probable nor estimable.  Because these matters are not probable orestimable, we have not recorded any reserves or contingencies related to theselegal matters.  In the event that ourassumptions used to evaluate these matters as neither probable nor estimablechanges in future periods, we may be required to record a liability for an adverseoutcome, which could have a material adverse effect on our results ofoperations and financial position.

*Impairment and Useful Lives ofLong-lived Assets*.  We review our long-lived tangible andintangible assets for impairment when events or changes in circumstancesindicate that the carrying value of an asset may not be recoverable.  We evaluate, at each balance sheet date,whether events and circumstances have occurred which indicate possibleimpairment.  The carrying value of along-lived asset is considered impaired when the anticipated cumulativeundiscounted cash flows of the related asset or group of assets is less thanthe carrying value.  In that event, aloss is recognized based on the amount by which the carrying value exceeds theestimated fair market value of the long-lived asset.  Economic useful lives of long-lived assetsare assessed and adjusted as circumstances dictate.

 

22

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Write-downs of intangible assets may be necessary ifthe future fair value of these assets is less than carrying value.  If the operating trends for our UNIX orSCOsource businesses continue to decline, we may be required to record animpairment charge in a future period related to the carrying value of ourlong-lived assets.

*Allowance for Doubtful Accounts Receivable*.  We offer credit terms on the sale of ourproducts to a majority of our customers and require no collateral from thesecustomers.  We perform ongoing creditevaluations of our customers’ financial condition and maintain an allowance fordoubtful accounts based upon our historical collection experience and expectedcollectibility of all accounts receivable and apply these policiesconsistently.  Our allowance for doubtfulaccounts receivable, which is determined based on our historical experience anda specific review of customer balances, was $119,000 as of April 30, 2006.  Our past experience has resulted in minimaldifferences from the actual amounts provided for bad debts and our recordedestimates.  However, our actual bad debtsin future periods may differ from our current estimates and the differences maybe material, whichmay have an adverse impact on our future accounts receivable and cash position.

**Results of Operations**

The following table presents our results of operationsfor the three and six months ended April 30, 2006 and 2005 (in thousands):
| *** ***                         | *** *** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | *** *** |
|--------------------------------------|--------------|----------------------------------|------------|--------------------------------|--------------|
| *** ***                         | *** *** | **2006**                         | ** ** | **2005**                       | ** **   | **2006** | ** ** | **2005** | *** *** |
| ** **                           |         |                             |       |                           |         |   |   |   |   |
| **Statement of Operations Data:**    |         |                             |       |                           |         |   |   |   |   |
| Revenue:                             |         |                             |       |                           |         |   |   |   |   |
| Products                             |         | $                                | 5,703      |                           | $            | 7,838 |   | $ | 11,703 |   | $ | 15,142 |   |
| SCOsource licensing                  |         | 34                               |       | 30                             |         | 64 |   | 100 |   |
| Services                             |         | 1,389                            |       | 1,390                          |         | 2,702 |   | 2,881 |   |
| Total revenue                        |         | 7,126                            |       | 9,258                          |         | 14,469 |   | 18,123 |   |
| Cost of revenue:                     |         |                             |       |                           |         |   |   |   |   |
| Products                             |         | 497                              |       | 563                            |         | 1,081 |   | 1,207 |   |
| SCOsource licensing                  |         | 3,762                            |       | 2,889                          |         | 7,772 |   | 6,382 |   |
| Services                             |         | 709                              |       | 746                            |         | 1,346 |   | 1,495 |   |
| Total cost of revenue                |         | 4,968                            |       | 4,198                          |         | 10,199 |   | 9,084 |   |
| Gross margin                         |         | 2,158                            |       | 5,060                          |         | 4,270 |   | 9,039 |   |
| Operating expenses:                  |         |                             |       |                           |         |   |   |   |   |
| Sales and marketing                  |         | 2,857                            |       | 2,970                          |         | 5,545 |   | 5,914 |   |
| Research and development             |         | 1,886                            |       | 2,117                          |         | 3,757 |   | 4,205 |   |
| General and administrative           |         | 1,718                            |       | 2,036                          |         | 3,310 |   | 3,799 |   |
| Amortization of intangibles          |         | 593                              |       | 593                            |         | 1,185 |   | 1,186 |   |
| Total operating expenses             |         | 7,054                            |       | 7,716                          |         | 13,797 |   | 15,104 |   |
| Loss from operations                 |         | (4,896                           | )          | (2,656                         | )            | (9,527 | ) | (6,065 | ) |
| Equity in income (loss) of affiliate |         | —                           |       | 17                             |         | (8 | ) | 70 |   |
| Other income, net                    |         | 316                              |       | 800                            |         | 461 |   | 1,309 |   |
| Provision for income taxes           |         | (114                             | )          | (123                           | )            | (201 | ) | (237 | ) |
| Net loss                             |         | $                                | (4,694     | )                              | $            | (1,962 | ) | $ | (9,275 | ) | $ | (4,923 | ) |

 

**THREEAND SIX MONTHS ENDED APRIL 30, 2006 AND 2005**

### ***Revenue***

| *** *** | *** *** | **Three Months Ended April 30,** | *** *** |
|--------------|--------------|----------------------------------|--------------|
| *** *** | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|         |         |                             |         |   |   |   |   |
| Revenue      |         | $                                | 7,126,000    |   | (23 | )% | $ | 9,258,000 |   |
|              |              |                                  |              |  |  |  |  |  |  |

 

23

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| *** *** | *** *** | **Six Months Ended April 30,** | ** ** |
|--------------|--------------|--------------------------------|------------|
| *** *** | *** *** | **2006**                       | ** ** | **Change** | ** ** | **2005** | ** ** |
|         |         |                           |       |   |   |   |   |
| Revenue      |         | $                              | 14,469,000 |   | (20 | )% | $ | 18,123,000 |   |
|              |              |                                |            |  |  |  |  |  |  |

 

Revenuefor the three months ended April 30, 2006 decreased by $2,132,000, or 23%, fromthe three months ended April 30, 2005, and revenue for the six months endedApril 30, 2006 decreased by $3,654,000, or 20%, from the six months ended April30, 2005.  These decreases were primarilyattributable to a continued decline in our UNIX business as a result ofcontinued competitive pressure from competing operating systems, particularlyLinux.

Revenuegenerated from our UNIX business and SCOsource business is as follows:

| *** ***             | *** *** | **Three Months Ended April 30,** | *** *** |
|--------------------------|--------------|----------------------------------|--------------|
| *** ***             | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                     |         |                             |         |   |   |   |   |
| UNIX revenue             |         | $                                | 7,092,000    |   | (23 | )% | $ | 9,228,000 |   |
| Percent of total revenue |         | 100                              | %            |   |   | 100 | % |
| SCOsource revenue        |         | 34,000                           |         | 13 | % | 30,000 |   |
| Percent of total revenue |         | 0                                | %            |   |   | 0 | % |
|                          |              |                                  |              |  |  |  |  |  |  |

 

| *** ***             | *** *** | **Six Months Ended April 30,** | *** *** |
|--------------------------|--------------|--------------------------------|--------------|
| *** ***             | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                     |         |                           |         |   |   |   |   |
| UNIX revenue             |         | $                              | 14,405,000   |   | (20 | )% | $ | 18,023,000 |   |
| Percent of total revenue |         | 100                            | %            |   |   | 99 | %  |
| SCOsource revenue        |         | 64,000                         |         | (36 | )% | 100,000 |   |
| Percent of total revenue |         | 0                              | %            |   |   | 1 | % |
|                          |              |                                |              |  |  |  |  |  |  |

 

Thedecrease in revenue in the UNIX business of $2,136,000, or 23%, for the threemonths ended April 30, 2006 compared to the three months ended April 30, 2005and the decrease in revenue of $3,618,000, or 20%, for the six months endedApril 30, 2006 compared to the six months ended April 30, 2005 was primarilyattributable to continued competition from other operating systems,particularly Linux.  We anticipate thatfor the remainder of the year ending October 31, 2006 our UNIX business and therelated revenue from the UNIX business will face significant competition fromLinux and other operating systems.

Salesof our UNIX products and services during the three and six months ended April 30,2006 were primarily to pre-existing customers. Our UNIX business revenue depends significantly on our ability to marketour products to existing customers and to generate upgrades from existingcustomers.  Our UNIX revenue may be lowerthan currently anticipated if we are not successful with our existing customersor if we lose the support of any of our existing hardware and software vendorsor our key industry partners withdraw their marketing and certification supportor direct their support to our competitors.

*Products Revenue*

| *** ***             | *** *** | **Three Months Ended April 30,** | *** *** |
|--------------------------|--------------|----------------------------------|--------------|
| *** ***             | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                     |         |                             |         |   |   |   |   |
| Products revenue         |         | $                                | 5,703,000    |   | (27 | )% | $ | 7,838,000 |   |
| Percent of total revenue |         | 80                               | %            |   |   | 85 | % |
|                          |              |                                  |              |  |  |  |  |  |  |

 

24

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| *** ***             | *** *** | **Six Months Ended April 30,** | *** *** |
|--------------------------|--------------|--------------------------------|--------------|
| *** ***             | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                     |         |                           |         |   |   |   |   |
| Products revenue         |         | $                              | 11,703,000   |   | (23 | )% | $ | 15,142,000 |   |
| Percent of total revenue |         | 81                             | %            |   |   | 84 | % |
|                          |              |                                |              |  |  |  |  |  |  |

 

Ourproducts revenue consists of software licenses for UNIX products such asOpenServer and UnixWare, as well as sales of UNIX-related products.  Products revenue also includes revenuederived from OEMs, distribution partners and large accounts.  We rely heavily on our two-tier distributionchannel and any disruption in our distribution channel could have an adverseimpact on future revenue.

Thedecrease in products revenue of $2,135,000, or 27%, for the three months endedApril 30, 2006 compared to the three months ended April 30, 2005 and thedecrease in products revenue of $3,439,000, or 23%, for the six months endedApril 30, 2006 compared to the six months ended April 30, 2005 were primarily attributable todecreased sales of OpenServer, UnixWare and other products primarily resultingfrom increased competition in the operating system market, particularly fromLinux.

Ourproducts revenue was derived primarily from sales of our OpenServer andUnixWare products.  Other productsrevenue consists mainly of product maintenance and other UNIX-related products.  Revenue for these products was as follows:

| *** ***                | *** *** | **Three Months Ended April 30,** | *** *** |
|-----------------------------|--------------|----------------------------------|--------------|
| *** ***                | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                        |         |                             |         |   |   |   |   |
| OpenServer revenue          |         | $                                | 3,370,000    |   | (28 | )% | $ | 4,664,000 |   |
| Percent of products revenue |         | 59                               | %            |   |   | 60 | % |
| UnixWare revenue            |         | 1,584,000                        |         | (34 | )% | 2,391,000 |   |
| Percent of products revenue |         | 28                               | %            |   |   | 30 | % |
| Other products revenue      |         | 749,000                          |         | (4 | )% | 783,000 |   |
| Percent of products revenue |         | 13                               | %            |   |   | 10 | % |
|                             |              |                                  |              |  |  |  |  |  |  |

 

| *** ***                 | *** *** | **Six Months Ended April 30,** | *** *** |
|------------------------------|--------------|--------------------------------|--------------|
| *** ***                 | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                         |         |                           |         |   |   |   |   |
| OpenServer revenue           |         | $                              | 6,991,000    |   | (19 | )% | $ | 8,677,000 |   |
| Percent of products  revenue |         | 60                             | %            |   |   | 57 | % |
| UnixWare revenue             |         | 3,309,000                      |         | (27 | )% | 4,527,000 |   |
| Percent of products  revenue |         | 28                             | %            |   |   | 30 | % |
| Other products revenue       |         | 1,403,000                      |         | (28 | )% | 1,938,000 |   |
| Percent of products  revenue |         | 12                             | %            |   |   | 13 | % |
|                              |              |                                |              |  |  |  |  |  |  |

 

Thedecreases in revenue for OpenServer and UnixWare for the three and six monthsended April 30, 2006 compared to the three and six months ended April 30, 2005are primarily the result of continued competition from other operating systems,particularly Linux.  The decrease inother products revenue is primarily attributable to decreased sales of productmaintenance due to fewer customers renewing or ordering product maintenance.

*SCOsourceLicensing Revenue*

| *** ***                | *** *** | **Three Months Ended April 30,** | *** *** |
|-----------------------------|--------------|----------------------------------|--------------|
| *** ***                | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                        |         |                             |         |   |   |   |   |
| SCOsource licensing revenue |         | $                                | 34,000       |   | 13 | % | $ | 30,000 |   |
|                             |              |                                  |              |  |  |  |  |  |  |

 

25

----

 

| *** ***                 | *** *** | **Six Months Ended April 30,** | *** *** |
|------------------------------|--------------|--------------------------------|--------------|
| *** ***                 | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                         |         |                           |         |   |   |   |   |
| SCOsource licensing  revenue |         | $                              | 64,000       |   | (36 | )% | $ | 100,000 |   |
|                              |              |                                |              |  |  |  |  |  |  |

 

Weinitiated our SCOsource business for the purpose of protecting and defendingour intellectual property rights in our UNIX source code and derivativeworks.  SCOsource licensing revenue was$34,000 for the three months ended April 30, 2006 compared to $30,000 for thethree months ended April 30, 2005 and SCOsource licensing revenue was $64,000for the six months ended April 30, 2006 compared to $100,000 for the six monthsended April 30, 2005.

Weare unable to predict the amount and timing of future SCOsource licensingrevenue, and if generated, the revenue will be sporadic.

*Services Revenue*

| *** ***             | *** *** | **Three Months Ended April 30,** | *** *** |
|--------------------------|--------------|----------------------------------|--------------|
| *** ***             | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                     |         |                             |         |   |   |   |   |
| Services revenue         |         | $                                | 1,389,000    |   | 0 | % | $ | 1,390,000 |   |
| Percent of total revenue |         | 20                               | %            |   |   | 15 | % |
|                          |              |                                  |              |  |  |  |  |  |  |

 

| *** ***             | *** *** | **Six Months Ended April 30,** | *** *** |
|--------------------------|--------------|--------------------------------|--------------|
| *** ***             | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                     |         |                           |         |   |   |   |   |
| Services revenue         |         | $                              | 2,702,000    |   | (6 | )% | $ | 2,881,000 |   |
| Percent of total revenue |         | 19                             | %            |   |   | 16 | % |
|                          |              |                                |              |  |  |  |  |  |  |

 

Servicesrevenue consists primarily of technical support fees, engineering servicesfees, professional services fees and consulting fees.  These fees are typically charged and invoicedseparately from UNIX products sales. Services revenue was flat for the three months ended April 30, 2006 ascompared to the three months ended April 30, 2005.  The decrease in services revenue of $179,000,or 6%, for the six months ended April 30, 2006 as compared to the six monthsended April 30, 2005 was primarily attributable to a decrease in the dollaramount of support and engineering services fees as well as to the decrease inproducts revenue.

Themajority of our support and professional services revenue continues to bederived from services for UNIX-based operating system products.  Our future level of services revenue dependsin part on our ability to generate UNIX products revenue from new customers aswell as to renew annual support and services agreements with existing UNIXcustomers.

*Cost of Products Revenue*

| *** ***                | *** *** | **Three Months Ended April 30,** | *** *** |
|-----------------------------|--------------|----------------------------------|--------------|
| *** ***                | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                        |         |                             |         |   |   |   |   |
| Cost of products revenue    |         | $                                | 497,000      |   | (12 | )% | $ | 563,000 |   |
| Percent of products revenue |         | 9                                | %            |   |   | 7 | % |
|                             |              |                                  |              |  |  |  |  |  |  |

 

| *** ***                | *** *** | **Six Months Ended April 30,** | *** *** |
|-----------------------------|--------------|--------------------------------|--------------|
| *** ***                | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                        |         |                           |         |   |   |   |   |
| Cost of products revenue    |         | $                              | 1,081,000    |   | (10 | )% | $ | 1,207,000 |   |
| Percent of products revenue |         | 9                              | %            |   |   | 8 | % |
|                             |              |                                |              |  |  |  |  |  |  |

 

26

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Costof products revenue consists of manufacturing costs, royalties to third-partyvendors, technology costs and overhead costs. Cost of products revenue decreased by $66,000, or 12%, for the threemonths ended April 30, 2006 as compared to the three months ended April 30,2005 and cost of products revenue decreased by $126,000, or 10%, for the sixmonths ended April 30, 2006 as compared to the six months ended April 30,2005.  The decrease in the dollar amountof cost of products revenue was primarily attributable to lower productsrevenue as margins did not vary considerably.

Forthe remaining quarters of the year ending October 31, 2006, we expect thedollar amount of our cost of products revenue to be generally consistent withthe cost of products revenue incurred during the three months ended April 30,2006 and that cost of products revenue as a percent of products revenue for theremaining quarters of the year ending October 31, 2006 will be generallyconsistent with that incurred during the three months ended April 30, 2006.

*Cost ofSCOsource Licensing Revenue*  

| *** ***                        | *** *** | **Three Months Ended April 30,** | *** *** |
|-------------------------------------|--------------|----------------------------------|--------------|
| *** ***                        | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                                |         |                             |         |   |   |   |   |
| Cost of SCOsource licensing revenue |         | $                                | 3,762,000    |   | 30 | % | $ | 2,889,000 |   |
|                                     |              |                                  |              |  |  |  |  |  |  |

 

| *** ***                        | *** *** | **Six Months Ended April 30,** | *** *** |
|-------------------------------------|--------------|--------------------------------|--------------|
| *** ***                        | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                                |         |                           |         |   |   |   |   |
| Cost of SCOsource licensing revenue |         | $                              | 7,772,000    |   | 22 | % | $ | 6,382,000 |   |
|                                     |              |                                |              |  |  |  |  |  |  |

 

Costof SCOsource licensing revenue includes legal and professional fees incurred inconnection with our SCO Litigation, the salaries and related personnel costs ofSCOsource employees, and an allocation of corporate costs.

Costof SCOsource licensing revenue increased by $873,000, or 30%, during the threemonths ended April 30, 2006 as compared to the three months ended April 30,2005 and increased by $1,390,000, or 22%, during the six months ended April 30,2006 as compared to the six months ended April 30, 2005.  The increase in costs for the three and sixmonths ended April 30, 2006 compared to the three and six months ended April30, 2005 was primarily attributable to increased costs for expert, technicaland industry, and damage consultants incurred in connection with our SCOLitigation.

Becauseof the unique and unpredictable nature of the SCO Litigation, the occurrenceand timing of certain expenses is difficult to predict, and will be difficultto predict for the upcoming quarters.  We will continue to make payments fortechnical, damage and industry experts, consultants and for other fees.  However, future legal fees may includecontingency payments made to the Law Firms as a result of a settlement,judgment, or a sale of our Company, which could cause the cost of SCOsourcelicensing revenue for the remaining quarters of the year ending October 31,2006 to be higher than the costs incurred for the three months ended April 30,2006.

*Cost of Services Revenue*

| *** ***                | *** *** | **Three Months Ended April 30,** | *** *** |
|-----------------------------|--------------|----------------------------------|--------------|
| *** ***                | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                        |         |                             |         |   |   |   |   |
| Cost of services revenue    |         | $                                | 709,000      |   | (5 | )% | $ | 746,000 |   |
| Percent of services revenue |         | 51                               | %            |   |   | 54 | % |
|                             |              |                                  |              |  |  |  |  |  |  |

 

27

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| *** ***                | *** *** | **Six Months Ended April 30,** | *** *** |
|-----------------------------|--------------|--------------------------------|--------------|
| *** ***                | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                        |         |                           |         |   |   |   |   |
| Cost of services revenue    |         | $                              | 1,346,000    |   | (10 | )% | $ | 1,495,000 |   |
| Percent of services revenue |         | 50                             | %            |   |   | 52 | % |
|                             |              |                                |              |  |  |  |  |  |  |

 

Costof services revenue includes the salaries and related personnel costs ofemployees delivering services revenue as well as third-party serviceagreements.  Cost of services revenuedecreased by $37,000, or 5%, for the three months ended April 30, 2006 comparedto the three months ended April 30, 2005 and decreased by $149,000, or 10%, forthe six months ended April 30, 2006 as compared to the six months ended April30, 2005.  This decrease was primarilyattributable to reduced numbers of employees and related costs.

Forthe remaining quarters of the year ending October 31, 2006, we expect thedollar amount of our cost of services revenue to be generally consistent withthe cost of services revenue incurred during the three months ended April 30,2006 and that cost of services revenue as a percent of services revenue for theremaining quarters of the year ending October 31, 2006 will be generallyconsistent with that incurred during the three months ended April 30, 2006.

*Sales and Marketing*

| *** ***                 | *** *** | **Three Months Ended April 30,** | *** *** |
|------------------------------|--------------|----------------------------------|--------------|
| *** ***                 | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                         |         |                             |         |   |   |   |   |
| Sales and marketing expenses |         | $                                | 2,857,000    |   | (4 | )% | $ | 2,970,000 |   |
| Percent of total revenue     |         | 40                               | %            |   |   | 32 | % |
|                              |              |                                  |              |  |  |  |  |  |  |

 

| *** ***                 | *** *** | **Six Months Ended April 30,** | *** *** |
|------------------------------|--------------|--------------------------------|--------------|
| *** ***                 | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                         |         |                           |         |   |   |   |   |
| Sales and marketing expenses |         | $                              | 5,545,000    |   | (6 | )% | $ | 5,914,000 |   |
| Percent of total revenue     |         | 38                             | %            |   |   | 33 | % |
|                              |              |                                |              |  |  |  |  |  |  |

 

Salesand marketing expenses consist of the salaries, commissions and other personnelcosts of employees involved in the revenue generation process, as well asadvertising and corporate allocations. The decrease in sales and marketing expenses of $113,000, or 4%, for thethree months ended April 30, 2006 compared with the three months ended April30, 2005 and the decrease of $369,000, or 6%, for the six months ended April30, 2006 compared with the six months ended April 30, 2005 was primarily attributable todecreased spending on co-operative advertising and decreased discretionaryspending.  Included in sales andmarketing expenses for the three months ended April 30, 2006 and 2005 was$91,000 and $7,000, respectively, for stock-based compensation.  Included in sales and marketing expenses forthe six months ended April 30, 2006 and 2005 was $159,000 and $14,000,respectively, for stock-based compensation. Our sales and marketing full-time equivalent employees increased from 52as of April 30, 2005 to 54 as of April 30, 2006.

Forthe remaining quarters of the year ending October 31, 2006, we anticipate thatthe dollar amount of sales and marketing expenses will be generally consistentwith that incurred during the three months ended April 30, 2006.

*Research and Development*

| *** ***                      | *** *** | **Three Months Ended April 30,** | *** *** |
|-----------------------------------|--------------|----------------------------------|--------------|
| *** ***                      | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                              |         |                             |         |   |   |   |   |
| Research and development expenses |         | $                                | 1,886,000    |   | (11 | )% | $ | 2,117,000 |   |
| Percent of total revenue          |         | 26                               | %            |   |   | 23 | % |
|                                   |              |                                  |              |  |  |  |  |  |  |

 

28

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| *** ***                      | *** *** | **Six Months Ended April 30,** | *** *** |
|-----------------------------------|--------------|--------------------------------|--------------|
| *** ***                      | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                              |         |                           |         |   |   |   |   |
| Research and development expenses |         | $3,757,000                     |         | (11 | )% | $4,205,000 |   |
| Percent of total revenue          |         | 26                             | %            |   |   | 23 | % |

 

Researchand development expenses consist of the salaries and benefits of softwareengineers, consulting expenses and corporate allocations.  Research and development expenses decreasedby $231,000, or 11%, for the three months ended April 30, 2006 compared withthe three months ended April 30, 2005 and decreased by $448,000, or 11%, forthe six months ended April 30, 2006 compared with the six months ended April30, 2005, which was primarily attributable to decreased personnel andpersonnel-related costs.  Included inresearch and development expenses for the three months ended April 30, 2006 and2005 was $36,000 and $0, respectively, of stock-based compensation.  Included in research and development expensesfor the six months ended April 30, 2006 and 2005 was $56,000 and $8,000,respectively, of stock-based compensation. Our research and development full-time equivalent employees decreasedfrom 52 as of April 30, 2005 to 49 as of April 30, 2006.

Forthe remaining quarters of the year ending October 31, 2006, we anticipate thatthe dollar amount of research and development expenses will be generallyconsistent with that incurred during the three months ended April 30, 2006.

*General and Administrative*

| *** ***                        | *** *** | **Three Months Ended April 30,** | *** *** |
|-------------------------------------|--------------|----------------------------------|--------------|
| *** ***                        | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                                |         |                             |         |   |   |   |   |
| General and administrative expenses |         | $                                | 1,718,000    |   | (16 | )% | $ | 2,036,000 |   |
| Percent of total revenue            |         | 24                               | %            |   |   | 22 | % |
|                                     |              |                                  |              |  |  |  |  |  |  |

 

| *** ***                        | *** *** | **Six Months Ended April 30,** | *** *** |
|-------------------------------------|--------------|--------------------------------|--------------|
| *** ***                        | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                                |         |                           |         |   |   |   |   |
| General and administrative expenses |         | $                              | 3,310,000    |   | (13 | )% | $ | 3,799,000 |   |
| Percent of total revenue            |         | 23                             | %            |   |   | 21 | % |
|                                     |              |                                |              |  |  |  |  |  |  |

 

Generaland administrative expenses consist of the salaries and benefits of finance,human resources, and executive management and expenses for professionalservices and corporate allocations. General and administrative expenses decreased by $318,000, or 16%,during the three months ended April 30, 2006 as compared to the three monthsended April 30, 2005 and decreased by $489,000, or 13%, during the six monthsended April 30, 2006 as compared to the six months ended April 30, 2005.  The decrease in general and administrativeexpenses was primarily attributable to decreased professional service fees attributedto accounting, auditing and legal work, offset, in part, by stock-basedcompensation.  Included in general andadministrative expenses for the three months ended April 30, 2006 and 2005 was$227,000 and $0, respectively, of stock-based compensation.  Included in general and administrativeexpenses for the six months ended April 30, 2006 and 2005 was $472,000 and $0,respectively, of stock-based compensation. Our general and administrative full-time equivalent employees decreasedfrom 29 as of April 30, 2005 to 28 as of April 30, 2006.

Forthe remaining quarters of the year ending October 31, 2006, we anticipate thatthe dollar amount of general and administrative expenses will be generallyconsistent to that incurred during the three months ended April 30, 2006.

 

29

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*Amortization of Intangibles*

| *** ***                | *** *** | **Three Months Ended April 30,** | *** *** |
|-----------------------------|--------------|----------------------------------|--------------|
| *** ***                | *** *** | **2006**                         | ** **   | **Change** | ** ** | **2005** | *** *** |
|                        |         |                             |         |   |   |   |   |
| Amortization of intangibles |         | $                                | 593,000      |   | 0 | % | $ | 593,000 |   |
| Percent of total revenue    |         | 8                                | %            |   |   | 6 | % |
|                             |              |                                  |              |  |  |  |  |  |  |

* *

| *** ***                | *** *** | **Six Months Ended April 30,** | *** *** |
|-----------------------------|--------------|--------------------------------|--------------|
| *** ***                | *** *** | **2006**                       | ** **   | **Change** | ** ** | **2005** | *** *** |
|                        |         |                           |         |   |   |   |   |
| Amortization of intangibles |         | $                              | 1,185,000    |   | 0 | % | $ | 1,186,000 |   |
| Percent of total revenue    |         | 8                              | %            |   |   | 7 | % |
|                             |              |                                |              |  |  |  |  |  |  |

 

*Equityin Income (Loss) of Affiliate*

We account for our ownership interests in companies inwhich we own at least 20 percent and less than 50 percent using the equitymethod of accounting.  Under the equitymethod, we record our portion of the entities’ net income or net loss in ourconsolidated statements of operations. As of April 30, 2006, the carrying value of our investments was $599,000and was related to our 30 percent ownership in a Chinese company.

Duringthe three months ended April 30, 2006 and 2005, we recorded $0 and $17,000,respectively, that related to equity in income (loss) of the Chinesecompany.  During the six months endedApril 30, 2006 and 2005, we recorded $(8,000) and $70,000, respectively, thatrelated to equity in income (loss) of the Chinese company.

*OtherIncome (Expense), net*

Otherincome (expense) consisted of the following components for the three and sixmonths ended April 30, 2006 and 2005:

| *** ***      | *** *** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|-------------------|--------------|----------------------------------|------------|--------------------------------|------------|
| *** ***      | *** *** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|              |         |                             |       |                           |       |   |   |   |   |
| Interest income   |         | $                                | 199,000    |                           | $          | 98,000 |   | $ | 351,000 |   | $ | 135,000 |   |
| Other income, net |         | 117,000                          |       | 702,000                        |       | 110,000 |   | 1,174,000 |   |
| Total             |         | $                                | 316,000    |                           | $          | 800,000 |   | $ | 461,000 |   | $ | 1,309,000 |   |
|                   |              |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |

 

Interestincome increased by $101,000 and $216,000, respectively, from the three and sixmonths ended April 30, 2005 as compared to the three and six months ended April30, 2006 and was primarily attributable to higher interest rates earned on ourcash and available-for-sale marketable securities balances as well as highercash and available-for-sale marketable securities balances.   The higher cash balance is primarilyattributable to our recent financing described in Note 6 to the Notes toCondensed Consolidated Financial Statements.

Thedecrease in other income, net, of $585,000 and $1,064,000, respectively, fromthe three and six months ended April 30, 2005 as compared to the three and sixmonths ended April 30, 2006 was primarily attributable to the collection of a$500,000 note receivable from Vintela, Inc. during the three months endedJanuary 31, 2005 and proceeds of approximately $779,000 we received during thethree months ended April 30, 2005 from the sale of shares we held of Troll TechAS.

 

30

----

 

*Provision for Income Taxes*

The provision for income taxes was $114,000 for thethree months ended April 30, 2006 and $123,000 for the three months ended April30, 2005 and was $201,000 for the six months ended April 30, 2006 and $237,000for the six months ended April 30, 2005. Our provision for incometaxes is primarily related to earnings in foreign subsidiaries as well as fromwithholding taxes on revenue generated in certain foreign locations.

**Liquidityand Capital Resources**

Ourcash and cash equivalents balance increased from $4,272,000 as of October 31,2005 to $9,524,000 as of April 30, 2006. During this same time period, our investment in available-for-salemarketable securities increased from $6,165,000 to $9,100,000.  Our working capital also increased from $8,669,000as of October 31, 2005 to $11,693,000 as of April 30, 2006.  These increases were primarily attributableto the issuance of approximately 2,852,000 shares of our common stock for netproceeds of approximately $9,809,000 in November 2005 offset by cashexpenditures related to the SCO Litigation.

Totalcash and cash equivalents and available-for-sale marketable securities were$18,624,000 as of April 30, 2006.  As ofApril 30, 2006, we also had $3,340,000 of restricted cash, of which $140,000 isset aside to cover expert and other costs related to our SCO Litigation and$3,200,000 is set aside for royalties payable to Novell.

We intend touse the cash and cash equivalents and available-for-sale marketable securitiesas of April 30,2006 to run ourUNIX business and pursue the SCO Litigation.

Ournet cash used in operating activities during the six months ended April 30,2006 was $1,836,000 and was attributable to a net loss of $9,275,000, non-cashitems of $2,350,000 and changes in operating assets and liabilities of$5,089,000.

Ournet cash used in operating activities during the six months ended April 30,2005 was $17,702,000.  Cash used inoperating activities for the six months ended April 30, 2005 was attributableto a net loss of $4,923,000, non-cash expenses of $1,521,000 and changes inoperating assets and liabilities of $14,300,000.

Our investingactivities have historically consisted of equipment purchases and the purchaseand sale of available-for-sale marketable securities.  During the six months ended April 30, 2006,cash used in investing activities was $3,088,000, which was primarily a resultof purchases, net of sales, of available-for-sale marketable securities of$2,935,000, and purchases of equipment of $153,000.

During the sixmonths ended April 30, 2005, cash provided by investing activities was$12,564,000, which was primarily a result of sales, net of purchases, ofavailable-for-sale marketable securities, of $12,709,000, which was offset, inpart, by purchases of property and equipment of $145,000.

Our financingactivities provided $10,110,000 of cash during the six months ended April 30,2006.  The primary sources of cash werethe net proceeds from the issuance of approximately 2,852,000 shares of ourcommon stock for $9,809,000, the exercise of options to acquire common stock of$32,000 and proceeds of $301,000 received from the sale of common stock throughour ESPP, offset, in part, by the repurchase of shares of our common stock madein connection with the completion of our rescission offer of $32,000.

Our financingactivities provided $578,000 of cash during the six months ended April 30, 2005and consisted primarily of proceeds received from the exercise of stock optionsof $205,000 and proceeds from the purchase of shares of common stock by ouremployees through our ESPP of $373,000.

 

31

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Our net accounts receivable balance decreased from$6,343,000 as of October 31, 2005 to $5,109,000 as of April 30, 2006, primarilyas a result of lower invoicing and revenue generated during the three monthsended April 30, 2006 as compared to the three months ended October 31,2005.  The majority of our accountsreceivable are current and our allowance for doubtful accounts was $119,000 asof April 30, 2006, which represented approximately 2 percent of our grossaccounts receivable balance.  Thispercentage of gross accounts receivable is consistent with our experience inprior periods, and we expect this trend to continue.  Our write-offs of uncollectible accountsduring the three months ended April 30, 2006 and 2005 were not significant.

On October 31, 2004, weentered into an engagement agreement (the “Engagement Agreement”) with the LawFirms.  The Engagement Agreementsupercedes and replaces the original engagement agreement that was entered intoin February 2003.  The EngagementAgreement governs the relationship between us and the Law Firms in connectionwith their representation of us in the SCO Litigation, through the end of ourcurrent litigation with IBM.  Our purposein entering into this Engagement Agreement was to limit the cash expendituresneeded to pursue the SCO Litigation.  TheEngagement Agreement provides for the payment of approximately $26,000,000 forall attorneys’ fees in connection with the SCO Litigation through the end ofour current litigation with IBM and the escrow of at least $5,000,000 for thepayment of any expert, consulting and other expenses.  As of April 30, 2006, we had paid the entire$26,000,000.  As of April 30, 2006,$140,000 remained in the escrow account and was classified as a component ofrestricted cash.  On June 5, 2006, weentered into an amendment to the Engagement Agreement and agreed with the LawFirms to deposit an additional $5,000,000 into the escrow account to coveradditional expert, consulting and other expenses.  In the event that we exhaust these funds, we willcontinue to pay for expert, consulting and other expenses through theconclusion of our litigation with IBM.

In addition to the cashexpenditures mentioned above, we must also pay one or more contingency feesupon any amount we or our stockholders may receive as a result of a settlement,judgment, or a sale of our Company.  Thecontingency fee amounts payable to the Law Firms will be, subject to certaincredits and adjustments, as follows:

•                  33 percent of any aggregaterecovery amounts received up to $350,000,000;

•                  plus 25 percent of anyaggregate recovery amounts above $350,000,000 but less than or equal to$700,000,000;

•                  plus 20 percentof any aggregate recovery amounts in excess of $700,000,000.

The Engagement Agreementspecifically provides that, except for the compensation obligationsspecifically described above, we will not be obligated to pay any legal fees,whether hourly, contingent or otherwise, to the Law Firms, or any other lawfirms that may be engaged by the Law Firms, in connection with the SCOLitigation through the end of the current litigation between us and IBM,including any appeals.

We have entered intooperating leases for our corporate offices located in the United States and ourinternational sales offices.  We havecommitments under these leases that extend through the year ending October 31,2008.

The following tablesummarizes our contractual operating lease obligations as of April 30, 2006: 
| *** ***                | *** *** | **Total** | ** ** | **Less than  1 year** | ** ** | **1 - 3 years** | ** ** | **3 - 5 years** | ** ** | **More than  5 years** | *** *** |
|-----------------------------|--------------|-----------|------------|-----------------------|------------|-----------------|------------|-----------------|------------|------------------------|--------------|
|                        |         |      |       |                  |       |            |       |            |       |                   |         |
| Operating lease obligations |         | $         | 1,899,000  |                  | $          | 1,159,000       |       | $               | 740,000    |                   | $            | — |   | $ | — |   |
|                             |              |           |            |                       |            |                 |            |                 |            |                        |              |  |  |  |  |  |

 

32

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As of April 30, 2006, we did not have any long-termdebt obligations, purchase obligations or material capital lease obligations.

Our ability to reduce costs to offset revenue declinesin our UNIX business is limited because of contractual commitments to maintainand support our existing UNIX customers. This decline in our UNIX business may be accelerated if industrypartners withdraw their support as a result of the SCO Litigation.  In addition, the SCO Litigation may causeindustry partners, developers and hardware and software vendors to choose notto support or certify to our UNIX operating system products.  This would lead to an accelerated decline inour UNIX products and services revenue.  If our UNIX products and services revenueis less than expected, our liquidity will be adversely impacted.

In the event that cash required to fund operations,the SCO Litigation and strategic initiatives exceeds our current cash resourcesand cash generated from operations, we will be required to reduce costs andperhaps raise additional capital.  We maynot be able to reduce costs in a manner that does not impair our ability tomaintain our UNIX business and pursue the SCO Litigation.  We may also not be able to raise capital forany number of reasons including those listed under Item 1A — Risk Factors.  If additional equity financing is available,it may not be available to us on attractive terms and may be dilutive to ourexisting stockholders.  In addition, ifour stock price declines, we may not be able to access the public equitymarkets on acceptable terms, if at all. Our ability to effect acquisitions for stock would also be impaired.

#### ***Forward-LookingStatements and Factors That May Affect Future Results and Financial Condition***

#### ***With the exception of historical facts, thestatements contained in Management’s Discussion and Analysis of FinancialCondition and Results of Operations are “forward-looking statements” within themeaning of the Private Securities Litigation Reform Act of 1995, which reflectour current expectations and beliefs regarding our future results ofoperations, performance and achievements. These statements are subject to risksand uncertainties and are based upon assumptions and beliefs that may or maynot materialize.  These forward-lookingstatements include, but are not limited to, statements concerning:***

•                              Our expectationthat our sales channel should continue to provide reliable UNIX operatingsystems for small-to-medium sized business customers;

•                              Our intentionto vigorously defend legal claims and counterclaims brought against us byothers;

•                              Our intentionto continue to pursue the SCO Litigation;

•                              Our expectationthat our UNIX business will generate positive cash flow during the year endingOctober 31, 2006;

•                              Our belief thatour allowance for doubtful accounts receivable will remain consistent with ourprior experience;

•                              The strength ofour intellectual property rights and contractual claims regarding UNIXgenerally and specifically the strength of our claim that unauthorized UNIXsource code and derivatives of UNIX source code are prevalent in Linux;

•                              Our belief thatcompetition from Linux will continue during the year ending October 31, 2006and future periods;

 

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•                              Our expectationthat we will continue to be unable to predict the amount and timing of SCOsourcelicensing revenue, and when generated, the revenue will be sporadic;

•                              Our expectationthat future services revenue will depend in part on our ability to generateUNIX products revenue from new customers as well as the renewal of annualsupport and services agreements from existing UNIX customers;

•                              Our expectationfor the remaining quarters of the year ending October 31, 2006 that the dollaramount of our cost of products revenue and that cost of products revenue as apercent of products revenue will be generally consistent to that generated orincurred during the three months ended April 30, 2006;

•                              Our expectationfor the remaining quarters of the year ending October 31, 2006 that the dollaramount of our cost of services revenue and that cost of services revenue as apercent of services revenue will be generally consistent to that generated orincurred during the three months ended April 30, 2006;

•                              Our expectationfor the remaining quarters of the year ending October 31, 2006 that the dollaramount of our sales and marketing expenses will be generally consistent to thatgenerated during the three months ended April 30, 2006;

•                              Our expectationfor the remaining quarters of the year ending October 31, 2006 that the dollaramount of our research and development expenses will be generally consistent tothat generated during the three months ended April 30, 2006;

•                              Our expectationfor the remaining quarters of the year ending October 31, 2006 that the dollaramount of our general and administrative expenses will be generally consistentto that generated during the three months ended April 30, 2006;

•                              Our expectationfor the remaining quarters of the year ending October 31, 2006 that because of the unique and unpredictablenature of the SCO Litigation, the occurrence and timing of certain expenses isdifficult to predict, and will be difficult to predict for the upcomingquarters;

•                              Our belief thatcertain legal actions to which we are a party will not have a material adverseeffect on us;

•                              Our intention to use cash and cashequivalents and available-for-sale marketable securities to run our UNIX business and pursue the SCO Litigation; and

•                              Our intention to continue to pay forexpert, consulting and other expenses through the conclusion of our litigationwith IBM.

We wish to caution readersthat our operating results are subject to various risks and uncertainties thatcould cause our actual results and outcomes to differ materially from thosediscussed or anticipated, including the resolution of the SCO Litigation,competition from other operating systems, particularly Linux, the amount andtiming of SCOsource licensing revenue, our ability to enhance our UNIXoperating systems and maintain our UNIX business, and the factors set forth inthe “Item 1A Risk Factors” below.  Wealso wish to advise readers not to place any undue reliance on theforward-looking statements contained in this report, which reflect our beliefsand expectations only as of the date of this report.  We assume no obligation to update or revisethese forward-looking statements to reflect new events or circumstances or anychanges in our beliefs or expectations, other than as required by law.

**ITEM 3.****                                                 ****QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

*ForeignCurrency Risk. *We have foreign offices and operations inEurope and Asia.  As a result, a portionof our revenue is derived from sales to customers outside the UnitedStates.  Our international revenue is denominatedin U.S. dollars, Euros and United Kingdom Pounds.  Most of the operating expenses related to ourforeign-based operations are denominated in foreign currencies and thereforeoperating results are affected by changes in the U.S. dollar exchange rate inrelation to foreign currencies such as the Euro, among others.  If the U.S. dollar further weakens comparedto the Euro, our operating expenses for foreign operations will be higher whentranslated back into U.S. dollars.  Ourrevenue can also be affected by general economic 

 

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conditions in the UnitedStates, Europe and other international markets. Our results of operations may be affected in the short term byfluctuations in foreign currency exchange rates.

*Interest Rate Risk. *Theprimary objective of our cash management strategy is to invest available fundsin a manner that assures maximum safety and liquidity and maximizes yieldwithin such constraints.  We believe thata hypothetical movement in interest rates, either up or down, would not have amaterial adverse impact on our cash and cash equivalents and available-for-salemarketable securities.  We do not borrowmoney for short-term investment purposes.

*Investment Risk. *We haveinvested in equity instruments of privately held and public companies in thetechnology industry for business and strategic purposes.  Investments are accounted for under the costmethod if our ownership is less than 20 percent and we are not able to exerciseinfluence over operations.  Ourinvestment policy is to regularly review the assumptions and operatingperformance of these companies and to record impairment losses when events andcircumstances indicate that these investments may be impaired.  As of April 30, 2006, our investments balancetotaled approximately $599,000 and consisted solely of our investment in a 30%owned Chinese company.

The stock market in general, and the market for sharesof technology companies in particular, has experienced price fluctuations.  In addition, factors such as new productintroductions by our competitors or developments in the SCO Litigation may havea significant impact on the market price of our common stock.  Furthermore, quarter-to-quarter fluctuationsin our results of operations may have a significant impact on the market priceof our common stock.  These conditionscould cause the price of our common stock to fluctuate substantially over shortperiods of time.

**ITEM 4.****                               ****CONTROLS AND PROCEDURES**

*Evaluation of disclosure controls and procedures.* Under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, we evaluatedthe effectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of1934 (the “Exchange Act”)).  Based uponthat evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that, as of the end of the period covered by this report, ourdisclosure controls and procedures were effective.

*Changes in internal control over financialreporting.*  During the most recent fiscal quarter coveredby this report, there has been no change in our internal control over financialreporting (as defined in Rule 13a-15(f) under the Exchange Act) that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

**PART II.                OTHERINFORMATION**

**ITEM 1.  LEGAL PROCEEDINGS**

Certainlegal proceedings in which we are involved are discussed in Part I,Item 3, of our Annual Report on Form 10-K for the year endedOctober 31, 2005.  The followingdiscussion is limited to certain recent developments concerning our legalproceedings and should be read in conjunction with our Annual Report on Form10-K.   In addition, for more informationregarding our legal proceedings, please see Note 4 included in Part 1, Item1.  Unaudited Financial Statements —Notes to Condensed Consolidated Financial Statements, which information isincorporated herein by reference.

 

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*IBMCorporation*

On February 13, 2006, IBM filed a motion with the Court seeking tolimit our claims.  IBM argues that of the294 items identified by us in our December 22, 2005 filing, 201 did not meetthe level of specificity required by the Court. IBM requested that we be limited to 93 items set forth in the December22, 2005 filing which IBM claims meet the required level of specificity.  We disagree with IBM’s motion and analysisand filed an opposition brief under seal with the Court.  The Court heard arguments on the matter onApril 14, 2006 and took the matter under advisement.  On June 8, 2006, IBM filed a motion toconfine our claims to, and strike allegations in excess of, the finaldisclosures.  In this motion, IBM claimsthat our technology expert reports go beyond the disclosures contained in ourDecember 22, 2005 submission to the court and that those expert reports shouldbe stricken to that extent.

*Novell, Inc.*

On or about April 10, 2006, Novell filed a motion to stay the case inUtah pending a Request for Arbitration that Novell filed on the same date inthe International Court of Arbitration in France.  Through these proceedings, Novell claims thatwe granted Novell the right to use our intellectual property through ourparticipation in the United Linux initiative in 2002.  Through its acquisition of SUSE Linux, GmbH,Novell claims it acquired all rights SUSE had as a member of United Linux.  On May 26, 2006, we filed a response toNovell’s motion to stay and we will respond to Novell’s request for arbitrationin due course.  No hearing on Novell’smotion has been scheduled.

**ITEM 1A.               RISK FACTORS**

                Investing in our securitiesinvolves a high degree of risk.  Inaddition to the other information contained in this Form 10-Q, you should considerthe following risk factors before investing in our securities.

*We donot have a history of profitable operations.*

Ouryear ended October 31, 2003 was the first full year we were profitable inour operating history.  Our profitabilityfor the year ended October 31, 2003 resulted primarily from our SCOsourcebusiness.  For the years ended October31, 2005 and 2004, we incurred net losses applicable to common stockholders of$10,726,000 and $16,227,000, respectively, and for the six months ended April30, 2006 we incurred a net loss of $9,275,000. As of April 30, 2006, our accumulated deficit was $244,217,000.

Ifour revenue from the sale of our UNIX products and services continues todecline, we will need to further reduce operating expenses to generate positivecash flow. We may not be able to further reduce operating expenses withoutdamaging our ability to support our existing UNIX business. Additionally, wemay not be able to achieve profitability through additional cost-cuttingactions.

OurUNIX products and services revenue has declined over the last several yearsprimarily as a result of continued competition from alternative operatingsystems, particularly Linux.  In ourresults of operations, we recognize revenue from agreements for support and maintenancecontracts and other long-term contracts that have been previously invoiced andare included in deferred revenue.  Ourfuture UNIX revenue may be adversely impacted and may continue to decline if weare unable to replenish these deferred revenue balances with long-termmaintenance and support contracts or replace them with other sustainablerevenue streams.  If we are unable togenerate positive cash flow and profitable operations, our business will beadversely impacted.

*We maynot prevail in our SCO Litigation, which may adversely affect our ability tocontinue in business.*

 

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Wecontinue to pursue the SCO Litigation and believe in the merits of ourcases.  In our action against IBM, weseek damages for claims generally relating to our allegation that IBM hasinappropriately used and distributed our UNIX source code and derivative worksin connection with its efforts to promote the Linux operating system.  IBM has responded to our claims and brought counterclaimsagainst us asserting generally that we do not have the right to assert claimsbased on our ownership of UNIX intellectual property against IBM or others inthe Linux market.  Discovery iscontinuing in the case.  If we do notprevail in our action against IBM, or if IBM is successful in its counterclaimsagainst us, our business and results of operations would be materially harmedand we may not be able to continue in business. The litigation with IBM and others will be costly, and our costs forlegal fees and related expenses have been and will continue to be substantialand may exceed our capital resources. Additionally, the market price of our common stock may be negativelyaffected as a result of developments in our legal action against IBM that maybe, or may be perceived to be, adverse to us.

Asa result of the SCO Litigation, participants in the Linux marketplace andothers affiliated with IBM or sympathetic to the Linux movement have takenactions attempting to negatively affect our business and our SCOsourceefforts.  Linux proponents have taken abroad range of actions against us, including, for example, attempting toinfluence participants in the markets in which we sell our products to reduce oreliminate the amount of our products and services they purchase from us.  We expect that similar efforts likely willcontinue.  There is a risk thatadditional participants in our marketplace will negatively view the SCOLitigation, and we may lose support from such participants.  Any of the foregoing could adversely affectour position in the marketplace, our results of operations, our stock price andour ability to stay in business.

Asa response to our claim that our UNIX source code and derivative works haveinappropriately been included in Linux, Novell has publicly asserted its beliefthat it owns certain copyrights in our UNIX source code, and it has filed 15copyright applications with the United States Copyright Office related toUNIX.  Novell has claimed to haveretained rights related to UNIX source code licenses, including the licensewith IBM.  Novell asserts it has theright to take action on behalf of SCO in connection with such licenses,including termination rights.  Novell haspurported to veto our termination of the IBM, Sequent and SGI licenses.  We have asserted that we obtained the UNIXbusiness, source code, claims and copyrights when we acquired the assets andoperations of the server and professional services groups from The Santa CruzOperation in May 2001, which had previously acquired all such assets andrights from Novell in 1995 pursuant to an asset purchase agreement, asamended.  In January 2004, inresponse to Novell’s actions, we brought suit against Novell for slander oftitle seeking relief for Novell’s alleged bad faith effort to interfere withour rights related to our UNIX source code and derivative works and ourUnixWare products.  Novell twiceunsuccessfully sought to have the case dismissed.

OnJuly 29, 2005, Novell filed its Answer and Counterclaims against us, assertingcounterclaims for our alleged breaches of the Asset Purchase Agreement betweenNovell and our predecessor-in-interest, The Santa Cruz Operation, Inc., forslander of title, restitution/unjust enrichment, an accounting related toNovell’s retained binary royalty stream, and for declaratory relief regardingNovell’s alleged rights under the Asset Purchase Agreement.  On or about December 30, 2005, we filed amotion for leave to amend our complaint to assert additional claims againstNovell, including copyright infringement, unfair competition and a breach ofNovell’s limited license to use our UNIX source code.  Novell did not oppose our motion so ourSecond Amended Complaint has been filed. On or about April 10, 2006, Novell filed a motion to stay the case inUtah pending a request for arbitration that Novell filed on the same date inthe International Court of Arbitration in France.  Through these proceedings, Novell claims thatwe granted Novell the right to use our intellectual property through ourparticipation in the United 

 

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Linuxinitiative in 2002.  Through itsacquisition of SUSE Linux, GmbH, Novell claims it acquired all rights SUSE hadas a member of United Linux.  On May 26,2006, we filed a response to Novell’s motion to stay and we will respond toNovell’s request for arbitration in due course.

Notwithstandingour assertions of full ownership of critical UNIX-related intellectual propertyrights, as set forth above, including copyrights, and even if we are successfulin our legal action against Novell and end users such as AutoZone andDaimlerChrysler, the efforts of Novell and the other Linux proponents describedabove may cause further damage to our business including our ability tomonetize our UNIX assets.  These effortsof Linux proponents also may increase the negative view some participants inour marketplace have regarding our SCO Litigation and may contribute tocreating confusion in the marketplace about the validity of our claim that theunauthorized use of our UNIX source code and derivative works in Linux violatesour contracts and copyrights.  Increasednegative perception and potential confusion about our claims in our marketplacecould impede our continued pursuit of the SCO Litigation and negatively impactour business.  For example, we believethat our decrease in SCOsource revenue has been, in part, attributable toNovell’s claim of UNIX copyright ownership, which may have caused potentialcustomers to delay or forego licensing until an outcome in this legal matterhas been reached.

*Weoperate in a highly competitive market and face significant competition from avariety of current and potential sources; many of our current and potentialcompetitors have greater financial and technical resources than we do; thus, wemay fail to compete effectively.*

Inthe operating system market, our competitors include IBM, Red Hat, Novell,Hewlett Packard, Sun, Microsoft and other Linux distributors.  These and other competitors are aggressivelypursuing the current UNIX operating system market. Many of these competitorshave access to substantially greater resources than we do.  The major competitive alternative to our UNIXproducts is Linux.  The expansion of ourcompetitors’ offerings may restrict the overall market available for our UNIXproducts, including some markets where we have been successful in the past.

Ourfuture success may depend in part on our ability to continue to meet theincreasing needs of our customers by supporting existing and emergingtechnologies.  If we do not enhance ourproducts to meet these evolving needs, we may not remain competitive and beable to sustain or grow our business. Additionally, because technologicaladvancement in the UNIX operating system market and alternative operatingsystem markets is progressing at an advanced pace, we will have to develop andintroduce enhancements to our existing products and any new products on atimely basis to keep pace with these developments, evolving industry standardsand changing customer requirements.  Ourfailure to meet any of these and other competitive pressures may render ourexisting products and services obsolete, which would have an adverse impact onour revenue and operations.

Thesuccess of our UNIX business will depend on the level of commitment andcertification we receive from industry partners and developers.  In recent years, we have seen hardware andsoftware vendors as well as software developers turn their certification andapplication development efforts toward Linux and elect not to continue tosupport or certify to our UNIX operating system products.  If this trend continues, our competitiveposition will be adversely impacted and our future revenue from our UNIXbusiness will decline.  The decline inour UNIX business may be accelerated if industry partners withdraw theirsupport from us for any reason, including our SCO Litigation.

*If themarket for UNIX continues to contract, our business will be harmed.*

 

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Ourrevenue from the sale of UNIX products has declined over the last severalyears.  This decrease in revenue has beenattributable primarily to increased competition from other operating systems,particularly Linux.  Our sales of UNIXproducts and services are primarily to existing customers. If the demand forUNIX products continues to decline, and we are unable to develop UNIX productsand services that successfully address a market demand, our UNIX revenue willcontinue to decline, industry participants may not certify to our operatingsystem and products, we may not be able to attract new customers or retainexisting customers and our business and results of operations will be adverselyaffected.  Because of the long adoptioncycle for operating system purchases and the long sales cycle of our operatingsystem products, we may not be able to reverse these revenue declines quickly.

*We maylose the support of industry partners leading to an accelerated decline in ourUNIX products and services revenue.*

Thedecline in our UNIX business and our SCO Litigation may cause industrypartners, developers and hardware and software vendors to choose not to supportor certify to our UNIX operating system products.  This would lead to an accelerated decline inour UNIX products and services revenue and would adversely impact our resultsof operations and liquidity.

*Ourclaims relating to our UNIX intellectual property may subject us to additionallegal proceedings.*

InAugust 2003, Red Hat brought a lawsuit against us asserting that the Linuxoperating system does not infringe on our UNIX intellectual property rights andseeking a declaratory judgment for non-infringement of copyrights and nomisappropriation of trade secrets.  Inaddition, Red Hat claims we have engaged in false advertising in violation ofthe Lanham Act, deceptive trade practices, unfair competition, tortiousinterference with prospective business opportunities, and trade libel anddisparagement.  Although this case iscurrently stayed pending the resolution of our suit against IBM, we intend tovigorously defend this action.  However,if Red Hat is successful in its claim against us, our business and results ofoperations could be materially harmed.

Inaddition, regulators or others in the Linux market and some foreign regulatorshave initiated or in the future may initiate legal actions against us, all ofwhich may negatively impact our operations and future operating performance.

*We relyon our indirect sales channel for distribution of our products, and anydisruption of our channel at any level could adversely affect the sales of ourproducts.*

Wehave a two-tiered distribution channel. The relationships we have developed with resellers allow us to offer ourproducts and services to a much larger customer base than we would otherwise beable to reach through our own direct sales and marketing efforts.  Some solution providers also purchasesolutions through our resellers, and we anticipate they will continue to doso.  Because we usually sell indirectlythrough resellers, we cannot control the relationships through which resellers,solution providers or equipment integrators purchase our products.  In turn, we do not control the presentation ofour products to end users.  Therefore,our sales could be affected by disruptions in the relationships between us andour resellers, between our resellers and solution providers, or betweensolution providers and end users.  Also,resellers and solution providers may choose not to emphasize our products totheir customers.  Any of theseoccurrences could diminish the effectiveness of our distribution channel andlead to decreased sales.

*Ourfuture SCOsource licensing revenue is uncertain.*

Weinitiated the SCOsource licensing effort in the year ended October 31,2003 to review the status of UNIX licensing and sublicensing agreements.  This effort resulted in the execution of 

 

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twosignificant vendor license agreements and generated $25,846,000 in revenueduring the year ended October 31, 2003. During the years ended October 31, 2004, and 2005, our SCOsourcelicensing revenue declined to only $829,000, and $166,000, respectively, andduring the six months ended April 30, 2006, our SCOsource licensing revenue was$64,000.  Because of a lack of historicalexperience and the uncertainties related to SCOsource licensing revenue, we areunable to estimate the amount and timing of future SCOsource licensing revenue,if any.  If we do receive revenue fromthis source, it may be sporadic and fluctuate from quarter to quarter.  Additionally, the success of theseinitiatives may depend on the strength of our intellectual property rights andcontractual claims regarding UNIX, including the strength of our claim thatunauthorized UNIX source code and derivative works are prevalent in Linux.

*Fluctuationsin our operating results or the failure of our operating results to meet theexpectations of public market analysts and investors may negatively impact ourstock price.*

Fluctuationsin our operating results or our failure to meet the expectations of analysts orinvestors, even in the short-term, could cause our stock price to declinesignificantly.  Because of the potentialfor significant fluctuations in our SCOsource licensing revenue in anyparticular period, you should not rely on comparisons of our results ofoperations as an indication of future performance.

Factorsthat may affect our results include:

•                                            ability tosuccessfully negotiate and complete licensing and other agreements related toour intellectual property;

•                                            the interestlevel of resellers in recommending our UNIX business solutions to end users andthe introduction, development, timing, competitive pricing and marketacceptance of our products and services and those of our competitors;

•                                            the activitiesof short sellers;

•                                            changes ingeneral economic conditions, such as recessions, that could affect capitalexpenditures in the software industry;

•                                            results of,developments in, or costs of our SCO Litigation;

•                                            changes inbusiness attitudes toward UNIX as a viable operating system compared to othercompeting systems, especially Linux;

•                                            the contingencyand other legal fees we may pay to the Law Firms representing us in our effortsto establish and defend our intellectual property rights; and

•                                            changes inattitudes of customers and partners due to the decline in our UNIX business andour aggressive position against the inclusion of our UNIX code and derivativeworks in Linux.

Wealso experience fluctuations in operating results in interim periods in Europeand the Asia Pacific regions due to seasonal slowdowns and economic conditionsin these areas.  Seasonal slowdowns inthese regions typically occur during the summer months.

Asa result of the factors listed above and elsewhere, it is possible that ourresults of operations may be below the expectations of public market analystsand investors in any particular period. This could cause our stock price to decline. If revenue falls below ourexpectations, and we are unable to quickly reduce our spending in response, ouroperating results will be lower than expected. Our stock price may fall inresponse to these events.

*Ourforeign-based operations and sales create special problems, including theimposition of governmental controls and taxes and fluctuations in currencyexchange rates that could hurt our results.*

 

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Wehave foreign operations, including development facilities, sales personnel andcustomer support operations in Europe, Latin America and Asia. These foreignoperations are subject to certain inherent risks, including:

•                                            potential lossof developed technology through piracy, misappropriation, or more lenient lawsregarding intellectual property protection;

•                                            imposition ofgovernmental controls, including trade restrictions and other tax requirements;

•                                            fluctuations incurrency exchange rates and economic instability;

•                                            longer paymentcycles for sales in foreign countries; and

•                                            seasonalreductions in business activity.

Inaddition, certain of our operating expenses are denominated in localcurrencies, creating risk of foreign currency translation losses that couldharm our financial results and cash flows. When we generate profits in foreign countries, our effective income taxrate is increased.

Duringthe three months ended April 30, 2004, our Indian office was assessedwithholding taxes by the Government of India Income Tax Department.  The Tax Department assessed a 15 percentwithholding tax on certain revenue transactions in India that the TaxDepartment deemed royalty revenue under the Income Tax Act. We have filed anappeal with the Tax Department and believe that revenue from our packagedsoftware does not qualify for royalty treatment and therefore would not besubject to withholding tax.  However, wemay be unsuccessful in our appeal against the Tax Department and be obligatedto pay the assessed taxable amounts.  Becauseof our international operations, we may be subject to additional withholding orother taxes from other international jurisdictions.

*If weare unable to retain key personnel in an intensely competitive environment, ouroperations could be adversely affected.*

Weneed to retain our key management, technical and support personnel.  Competition for qualified professionals inthe software industry is intense, and departures of existing personnel could bedisruptive to our business and might result in the departure of otheremployees.  The loss or departure of anyofficers or key employees could harm our ability to implement our business planand could adversely affect our operations. Our future success depends to a significant extent on the continuedservice and coordination of our management team, particularly Darl C. McBride,our President and Chief Executive Officer.

*OurEngagement Agreement with the Law Firms representing us in the SCO Litigationrequires us to pay for expert, consulting and other costs, which could harm ourliquidity position if these costs are higher than anticipated.*

Asof April 30, 2006, we had a total of $18,624,000 in cash and cash equivalentsand available-for-sale marketable securities and an additional $140,000 ofrestricted cash to be used to pursue the SCO Litigation.  Since October 31, 2004, we have spent$4,860,000 for expert, consulting and other costs as agreed to in theEngagement Agreement with our legal counsel in the SCO Litigation.  On June 5, 2006, we entered into an amendmentto the Engagement Agreement and agreed with the Law Firms to deposit anadditional $5,000,000 into the escrow account to cover additional expert,consulting and other expenses.  In theevent that we exhaust these funds, we will continue to pay for expert,consulting and other expenses through the conclusion of our litigation withIBM.  As we continue with discovery andother trial preparations, we may be required to place additional amounts intothe escrow account, which could harm our liquidity position.

 

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*We haveissued options under our equity compensation plans without complying withregistration or qualification requirements under the securities laws ofCalifornia, Georgia and possibly other states, and, as a result, we may incurrescission liability for such options and may face additional potential claimsunder state securities laws.*

Inaddition to the shares issued under the ESPP, we have granted options under our1999 Omnibus Stock Incentive Plan and 2002 Omnibus Stock Incentive Plan withoutcomplying with the registration or qualification requirements under thesecurities laws of California, Georgia and possibly other states.  We may face rescission liability to planparticipants holding unexercised stock options in these states.  Additionally, regulatory authorities mayrequire us to pay fines or they may impose other sanctions upon us, and we mayface other claims by plan participants other than rescission claims.

*Ourstock price is volatile.*

Thetrading price for our common stock has been volatile during the last severalyears and our share price has changed dramatically over short periods.  We believe that changes in our stock priceare affected by the factors mentioned above under the caption entitled *“Fluctuations in our operating results or the failure of our operatingresults to meet the expectations of public market analysts and investors maynegatively impact our stock price”*as well as from changing publicperceptions concerning the strength of our intellectual property claims andother factors beyond our control.  Publicperception can change quickly and without any change or development in ourunderlying business or litigation position. An investment in our stock is subject to such volatility and,consequently, is subject to significant risk.

*Thereare risks associated with the potential exercise of our outstanding options.*

Asof May 31, 2006, we have issued outstanding options to purchase up toapproximately 4,742,000 shares of common stock with an average exercise priceof $4.13 per share.  The existence ofsuch rights to acquire common stock at fixed prices may prove a hindrance toour efforts to raise future equity and debt funding, and the exercise of suchrights will dilute the percentage ownership interest of our stockholders andmay dilute the value of their ownership. The possible future sale of shares issuable on the exercise ofoutstanding options could adversely affect the prevailing market price for ourcommon stock.  Further, the holders ofthe outstanding stock options may exercise them at a time when we wouldotherwise be able to obtain additional equity capital on terms more favorableto us.

*Commonstock available for resale may depress the market price of our common stock.*

Wehave filed a post-effective amendment to a registration statement with theSecurities and Exchange Commission (“SEC”), which has been declared effective,covering the potential resale by two of our shareholders of up to 923,019shares of common stock, or 4.4% of our outstanding common stock. The sellingshareholders are bound by certain selling limitations which limit the numbersof shares of our common stock that may be sold at one time.  In addition, we have filed a registrationstatement with the SEC, which has been declared effective, covering thepotential resale by some of our shareholders of up to 2,852,449 shares of ourcommon stock, or 13.5% of our outstanding common stock.  The existence of a substantial number ofshares of common stock subject to immediate resale could depress the marketprice for our common stock and impair our ability to raise needed capital.

*Ourstock price could decline further because of the activities of short sellers.*

Ourstock has attracted significant interest from short sellers.  The activities of short sellers could furtherreduce the price of our stock or inhibit increases in our stock price.

 

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*Theright of our Board of Directors to authorize additional shares of preferredstock could adversely impact the rights of holders of our common stock.*

OurBoard of Directors currently has the right, with respect to the 5,000,000shares of our preferred stock, to authorize the issuance of one or moreadditional series of our preferred stock with such voting, dividend and otherrights as our directors determine.  TheBoard of Directors can designate new series of preferred stock without theapproval of the holders of our common stock. The rights of holders of our common stock may be adversely affected bythe rights of any holders of additional shares of preferred stock that may beissued in the future, including without limitation, further dilution of theequity ownership percentage of our holders of common stock and their votingpower if we issue preferred stock with voting rights.  Additionally, the issuance of preferred stockcould make it more difficult for a third party to acquire a majority of ouroutstanding voting stock.

*Ourstockholder rights plan could make it more difficult for a hostile bid for ourcompany or a change of control transaction to succeed at current market pricesfor our stock.*

We have adopted a stockholder rights plan.  The power given to the Board of Directors bythe stockholder rights plan may make it more difficult for a change of controlof our company to occur or for our company to be acquired if the acquisition isopposed by our Board of Directors.

**ITEM 4.  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

The following matters were submitted to andapproved by our stockholders at our annual meeting held April 27, 2006:

1.                                     To elect eight members to the Board ofDirectors to serve until their successors have been appointed.  All directors were elected with Ralph J.Yarro III receiving 18,421,000 votes in favor and 260,000 votes withheld,Edward E. Iacobucci receiving 18,516,000 votes in favor and 165,000 voteswithheld; R. Duff Thompson receiving 18,533,000 votes in favor and 148,000votes withheld; Darcy G. Mott receiving 18,516,000 votes in favor and 165,000votes withheld; Darl C. McBride receiving 18,644,000 votes in favor and 37,000votes withheld; Daniel W. Campbell receiving 18,532,000 votes in favor and149,000 votes withheld; Omar T. Leeman receiving 18,515,000 votes in favor and166,000 votes withheld; and J. Kent Millington receiving 18,627,000 votes infavor and 54,000 votes withheld.

2.                                       To ratify the appointment of Tanner LC asindependent registered public accounting firm. This motion was passed with 18,651,000 votes in favor, 8,000 votesagainst, and 22,000 abstentions.

**ITEM 6.  EXHIBITS**

(a)                                  Exhibits

3.1                                 Amended andRestated Certificate of Incorporation of Caldera International, Inc.(incorporated by reference to Exhibit 3.1 to SCO’s Registration Statement onForm 8-A12G/A (File No. 000-29911)).

3.2                                 Certificate ofAmendment to Amended and Restated Certificate of Incorporation regardingconsolidation of outstanding shares (incorporated by reference to Exhibit 3.2to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).

 

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3.3                                 Certificate ofAmendment to Amended and Restated Certificate of Incorporation regarding changeof name to The SCO Group, Inc. (incorporated by reference to Exhibit 3.3 to SCO’sRegistration Statement on Form 8A12G/A (File No. 000-29911)).

3.4                               Amended andRestated Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s RegistrationStatement on Form 8-A12G/A (File No. 000-29911)).

3.5                                 Certificate ofDesignation for Series A-1 Convertible Preferred Stock (incorporated byreference to Exhibit 4.1 to SCO’s Current Report on Form 8-K filed on February9, 2004 (File No. 000-29911)).

3.6                                 Certificate ofCorrection correcting the Certificate of Designation for Series A-1 ConvertiblePreferred Stock (incorporated by reference to Exhibit 4.2 to SCO’s CurrentReport on Form 8-K filed on February 9, 2004 (File No. 000-29911)).

31.1                           Certificationof Darl C. McBride, President and Chief Executive Officer, pursuant to Rule13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of theSarbanes-Oxley Act of 2002.

31.2                           Certificationof Bert B. Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of theExchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1               Certification of Darl C. McBride, President andChief Executive Officer, pursuant to Section 1350, Chapter 63 of Title 18,United States Code, as adopted pursuant to Section 906 of the Sarbanes-OxleyAct of 2002.

32.2                           Certificationof Bert B. Young, Chief Financial Officer, pursuant to Section 1350, Chapter 63of Title 18, United States Code, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

**ITEM 7.            SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
| Date: June 13, 2006 | THE SCO GROUP, INC. |
|---------------------|---------------------|
|                |                |
|                | By:                 |   | /s/ Bert B. Young |
|                |                |   | Bert B. Young |
|                |                |   | Duly Authorized Officer  and Chief Financial Officer |
|                |                |   | (Principal Financial and Accounting  Officer) |

 

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** **

**EXHIBITINDEX**

** **

** **
| **Exhibit Number** | ** ** | **Exhibit  Description**                                                                                                                                                                                                                                |
|--------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **         | ** ** | ** **                                                                                                                                                                                                                                              |
| 3.1                |       | Amended  and Restated Certificate of Incorporation of Caldera International, Inc.  (incorporated by reference to Exhibit 3.1 to SCO’s Registration Statement on  Form 8-A12G/A (File No. 000-29911)).                                         |
|               |       |                                                                                                                                                                                                                                                    |
| 3.2                |       | Certificate  of Amendment to Amended and Restated Certificate of Incorporation regarding  consolidation of outstanding shares (incorporated by reference to Exhibit 3.2  to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).   |
|               |       |                                                                                                                                                                                                                                                    |
| 3.3                |       | Certificate  of Amendment to Amended and Restated Certificate of Incorporation regarding  change of name to The SCO Group, Inc. (incorporated by reference to Exhibit  3.3 to SCO’s Registration Statement on Form 8A12G/A (File No.  000-29911)). |
|               |       |                                                                                                                                                                                                                                                    |
| 3.4                |       | Amended  and Restated Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s  Registration Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                    |
|               |       |                                                                                                                                                                                                                                                    |
| 3.5                |       | Certificate  of Designation for Series A-1 Convertible Preferred Stock (incorporated by  reference to Exhibit 4.1 to SCO’s Current Report on Form 8-K filed on  February 9, 2004 (File No. 000-29911)).                                            |
|               |       |                                                                                                                                                                                                                                                    |
| 3.6                |       | Certificate  of Correction correcting the Certificate of Designation for Series A-1 Convertible  Preferred Stock (incorporated by reference to Exhibit 4.2 to SCO’s Current  Report on Form 8-K filed on February 9, 2004 (File No. 000-29911)).   |
|               |       |                                                                                                                                                                                                                                                    |
| 31.1               |       | Certification  of Darl C. McBride, President and Chief Executive Officer, pursuant to Rule  13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                       |
|               |       |                                                                                                                                                                                                                                                    |
| 31.2               |       | Certification  of Bert Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of the  Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                          |
|               |       |                                                                                                                                                                                                                                                    |
| 32.1               |       | Certification  of Darl C. McBride, President and Chief Executive Officer, pursuant to  Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.                                 |
|               |       |                                                                                                                                                                                                                                                    |
| **32.2**           | ** ** | **Certification of Bert Young, Chief Financial  Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States  Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**                                                 |

 

 

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