**UNITED STATES**

 

**SECURITIESAND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark one)**

**ý****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended July 31, 2005**

 

**OR**

 

**o****        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from             to            **

 

**Commission file number 0-29911**

 

**THE SCOGROUP, INC.**

(Exact name of registrant as specified in itscharter)

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

 

**355 South 520 West**

**Suite 100**

**Lindon, Utah 84042**

(Address of principal executive offices andzip code)

 

**(801) 765-4999**

(Registrant’s telephone number, including areacode)

 

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

 

YES ýNO o

 

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

 

YES oNO ý

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

 

YES oNO ý

 

As of September 8, 2005, there were 18,037,735shares of the Registrant’s common stock, $0.001 par value per share, outstanding.

 

 

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**The SCOGroup, Inc.**

 

**Table of Contents**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                                             |   |
|---------------|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.       | Unaudited  Financial Statements                                                                                                                   |   |
|          | Condensed Consolidated  Balance Sheets as of July 31, 2005 and October 31, 2004                                                         |   |
|          | Condensed  Consolidated Statements of Operations and Comprehensive Income (Loss) for the  three and nine months ended July 31, 2005 and 2004 |   |
|          | Condensed Consolidated  Statements of Cash Flows for the nine months ended July 31, 2005 and  2004                                           |   |
|          | 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                                                                                                                           |   |
|          | Forward-Looking Statements                                                                                                                        |   |
|          | Risk  Factors                                                                                                                                     |   |
| PART II. | OTHER INFORMATION                                                                                                                                 |   |
| Item 1.       | Legal Proceedings                                                                                                                                 |   |
| Item 2.       | Unregistered Sales of Equity  Securities and Use of Proceeds                                                                                      |   |
| Item 4.       | Submission of Matters to a Vote of  Security Holders                                                                                              |   |
| Item 6.       | Exhibits                                                                                                                                          |   |
|          | Signatures                                                                                                                                        |   |

 

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

 

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(in thousands, except per share data)**

 
| ** **                                                                                                    | ** ** | **July 31,** | ** ** | **October 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                                                                                    | ** ** | **2005**          | ** ** | **2004**             | ** ** |
| ** **                                                                                                    | ** ** | **(unaudited)**   | ** ** |
| **ASSETS**                                                                                                    | ** ** | ** **        | ** ** | ** **           | ** ** |
|                                                                                                          |       |              |       |                 |       |
| CURRENT ASSETS:                                                                                               |       |              |       |                 |       |
| Cash and cash equivalents                                                                                     |       | $                 | 6,526      |                 | $          | 12,693 |   |
| Restricted cash                                                                                               |       | 4,004             |       | 8,283                |       |
| Available-for-sale securities                                                                                 |       | 6,076             |       | 18,756               |       |
| Accounts receivable, net of allowance for doubtful  accounts of $109 and $136, respectively                   |       | 4,947             |       | 6,638                |       |
| Other current assets                                                                                          |       | 2,376             |       | 1,870                |       |
| Total current assets                                                                                          |       | 23,929            |       | 48,240               |       |
|                                                                                                          |       |              |       |                 |       |
| PROPERTY AND  EQUIPMENT:                                                                                      |       |              |       |                 |       |
| Computer and office equipment                                                                                 |       | 2,183             |       | 2,991                |       |
| Leasehold improvements                                                                                        |       | 389               |       | 406                  |       |
| Furniture and fixtures                                                                                        |       | 96                |       | 103                  |       |
|                                                                                                          |       | 2,668             |       | 3,500                |       |
| Less accumulated depreciation and amortization                                                                |       | (2,090            | )          | (2,851               | )          |
| Net property and equipment                                                                                    |       | 578               |       | 649                  |       |
|                                                                                                          |       |              |       |                 |       |
| OTHER ASSETS:                                                                                                 |       |              |       |                 |       |
| Intangibles, net                                                                                              |       | 3,383             |       | 5,413                |       |
| Other assets                                                                                                  |       | 1,118             |       | 1,098                |       |
| Total other assets                                                                                            |       | 4,501             |       | 6,511                |       |
|                                                                                                          |       |              |       |                 |       |
| Total assets                                                                                                  |       | $                 | 29,008     |                 | $          | 55,400 |   |
|                                                                                                          |       |              |       |                 |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                 | ** ** | ** **        | ** ** | ** **           | ** ** |
|                                                                                                          |       |              |       |                 |       |
| CURRENT  LIABILITIES:                                                                                         |       |              |       |                 |       |
| Accounts payable                                                                                              |       | $                 | 1,337      |                 | $          | 7,854 |   |
| Payable to Novell, Inc.                                                                                  |       | 425               |       | 3,283                |       |
| Accrued compensation to law firms                                                                             |       | —            |       | 7,956                |       |
| Accrued payroll and benefits                                                                                  |       | 2,270             |       | 3,369                |       |
| Accrued liabilties                                                                                            |       | 3,179             |       | 3,855                |       |
| Deferred revenue                                                                                              |       | 4,021             |       | 4,877                |       |
| Other royalties payable                                                                                       |       | 311               |       | 354                  |       |
| Income taxes payable                                                                                          |       | 1,323             |       | 1,279                |       |
| Total current liabilities                                                                                     |       | 12,866            |       | 32,827               |       |
|                                                                                                          |       |              |       |                 |       |
| OTHER LONG-TERM  LIABILITIES                                                                                  |       | 340               |       | 343                  |       |
|                                                                                                          |       |              |       |                 |       |
| COMMITMENTS AND  CONTINGENCIES (Note 5)                                                                       |       |              |       |                 |       |
|                                                                                                          |       |              |       |                 |       |
| COMMON STOCK  SUBJECT TO RESCISSION (Note 6)                                                                  |       | 1,104             |       | 528                  |       |
|                                                                                                          |       |              |       |                 |       |
| STOCKHOLDERS’  EQUITY:                                                                                   |       |              |       |                 |       |
| Common stock, $0.001 par value; 45,000 shares  authorized, 18,327 and 17,956 shares outstanding, respectively |       | 18                |       | 18                   |       |
| Additional paid-in capital                                                                                    |       | 246,652           |       | 246,273              |       |
| Common stock held in treasury - 290 shares                                                                    |       | (2,414            | )          | (2,414               | )          |
| Warrants outstanding                                                                                          |       | 1,099             |       | 1,099                |       |
| Deferred compensation                                                                                         |       | —            |       | (22                  | )          |
| Accumulated other comprehensive income                                                                        |       | 854               |       | 964                  |       |
| Accumulated deficit                                                                                           |       | (231,511          | )          | (224,216             | )          |
| Total stockholders’ equity                                                                               |       | 14,698            |       | 21,702               |       |
|                                                                                                          |       |              |       |                 |       |
| Total liabilities and stockholders’ equity                                                               |       | $                 | 29,008     |                 | $          | 55,400 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

4

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**THESCO GROUP, INC. AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS**

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

 
| ** **                                                                                                  | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                  | ** ** | **(unaudited)**                      | ** ** | **(unaudited)**                     | ** ** |
| REVENUE:                                                                                                    |       |                                 |       |                                |       |   |   |   |   |
| Products                                                                                                    |       | $                                    | 7,953      |                                | $          | 8,929 |   | $ | 23,095 |   | $ | 27,056 |   |
| SCOsource licensing                                                                                         |       | 32                                   |       | 678                                 |       | 132 |   | 709 |   |
| Services                                                                                                    |       | 1,368                                |       | 1,598                               |       | 4,249 |   | 4,969 |   |
| Total revenue                                                                                               |       | 9,353                                |       | 11,205                              |       | 27,476 |   | 32,734 |   |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| COST OF REVENUE:                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| Products                                                                                                    |       | 695                                  |       | 741                                 |       | 1,902 |   | 2,364 |   |
| SCOsource licensing                                                                                         |       | 3,085                                |       | 7,396                               |       | 9,467 |   | 15,486 |   |
| Services                                                                                                    |       | 700                                  |       | 878                                 |       | 2,195 |   | 3,273 |   |
| Total cost of revenue                                                                                       |       | 4,480                                |       | 9,015                               |       | 13,564 |   | 21,123 |   |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| GROSS MARGIN                                                                                                |       | 4,873                                |       | 2,190                               |       | 13,912 |   | 11,611 |   |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| OPERATING  EXPENSES:                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| Sales and marketing (exclusive of stock-based  compensation of $0, $15, $14, and $61, respectively)         |       | 2,935                                |       | 4,233                               |       | 8,835 |   | 13,952 |   |
| Research and development (exclusive of stock-based  compensation of $0, $12, $8, and $36, respectively)     |       | 1,940                                |       | 2,592                               |       | 6,137 |   | 8,167 |   |
| General and administrative (exclusive of stock-based  compensation of $0, $243, $0, and $771, respectively) |       | 1,647                                |       | 1,889                               |       | 5,446 |   | 5,793 |   |
| Loss on impairment of long-lived assets                                                                     |       | —                               |       | —                              |       | — |   | 2,139 |   |
| Severance and exit costs                                                                                    |       | —                               |       | —                              |       | — |   | 682 |   |
| Amortization of intangibles                                                                                 |       | 593                                  |       | 593                                 |       | 1,779 |   | 1,973 |   |
| Stock-based compensation                                                                                    |       | —                               |       | 270                                 |       | 22 |   | 868 |   |
| Total operating expenses                                                                                    |       | 7,115                                |       | 9,577                               |       | 22,219 |   | 33,574 |   |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| LOSS FROM  OPERATIONS                                                                                       |       | (2,242                               | )          | (7,387                              | )          | (8,307 | ) | (21,963 | ) |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| EQUITY IN INCOME  (LOSS) OF AFFILIATE                                                                       |       | (19                                  | )          | 41                                  |       | 51 |   | 115 |   |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                                                                                    |       |                                 |       |                                |       |   |   |   |   |
| Interest income                                                                                             |       | 122                                  |       | 186                                 |       | 257 |   | 698 |   |
| Change in fair value of derivative                                                                          |       | —                               |       | —                              |       | — |   | 5,924 |   |
| Other income (expense), net                                                                                 |       | (149                                 | )          | (87                                 | )          | 1,025 |   | (338 | ) |
| Total other income (expense), net                                                                           |       | (27                                  | )          | 99                                  |       | 1,282 |   | 6,284 |   |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| LOSS BEFORE  INCOME TAXES                                                                                   |       | (2,288                               | )          | (7,247                              | )          | (6,974 | ) | (15,564 | ) |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| PROVISION FOR INCOME  TAXES                                                                                 |       | (84                                  | )          | (176                                | )          | (321 | ) | (1,270 | ) |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| NET LOSS                                                                                                    |       | (2,372                               | )          | (7,423                              | )          | (7,295 | ) | (16,834 | ) |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| CONTRIBUTIONS FROM (DIVIDENDS ON) REDEEMABLE CONVERTIBLE  PREFERRED STOCK                                   |       | —                               |       | 14,924                              |       | — |   | 7,123 |   |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| NET INCOME ATTRIBUTABLE (LOSS APPLICABLE) TO COMMON  STOCKHOLDERS                                           |       | $                                    | (2,372     | )                                   | $          | 7,501 |   | $ | (7,295 | ) | $ | (9,711 | ) |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| BASIC NET INCOME  (LOSS) PER COMMON SHARE                                                                   |       | $                                    | (0.13      | )                                   | $          | 0.49 |   | $ | (0.41 | ) | $ | (0.67 | ) |
| DILUTED NET INCOME (LOSS) PER COMMON SHARE                                                                  |       | $                                    | (0.13      | )                                   | $          | 0.38 |   | $ | (0.41 | ) | $ | (0.67 | ) |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| WEIGHTED AVERAGE BASIC COMMON SHARES OUTSTANDING                                                            |       | 17,993                               |       | 15,242                              |       | 17,885 |   | 14,389 |   |
| WEIGHTED AVERAGE DILUTED COMMON SHARES OUTSTANDING                                                          |       | 17,993                               |       | 19,912                              |       | 17,885 |   | 14,389 |   |
|                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| OTHER  COMPREHENSIVE LOSS                                                                                   |       |                                 |       |                                |       |   |   |   |   |
| Net loss                                                                                                    |       | $                                    | (2,372     | )                                   | $          | (7,423 | ) | $ | (7,295 | ) | $ | (16,834 | ) |
| Unrealized gain (loss) on available-for-sale  securities, net of tax                                        |       | 5                                    |       | (42                                 | )          | 14 |   | (160 | ) |
| Foreign currency translation adjustment, net of tax                                                         |       | (128                                 | )          | (132                                | )          | (124 | ) | 16 |   |
| COMPREHENSIVE  LOSS                                                                                         |       | $                                    | (2,495     | )                                   | $          | (7,597 | ) | $ | (7,405 | ) | $ | (16,978 | ) |
|                                                                                                             |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to condensed consolidated financial statements.

 

5

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**THESCO GROUP, INC. AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

 
| ** **                                                                                                                         | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                         | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                                                                                                         | ** ** | **(unaudited)**                     | ** ** |
| * *                                                                                                                           | * *   | * *                            | * *   | * * | * * |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                                                             |       |                                |       |   |   |
| Net loss                                                                                                                           |       | $                                   | (7,295     | ) | $ | (16,834 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities:                                                       |       |                                |       |   |   |
| Amortization of intangibles (including $251 and $253  classified as cost of SCOsource licensing revenue)                           |       | 2,030                               |       | 2,223 |   |
| Depreciation and amortization                                                                                                      |       | 271                                 |       | 629 |   |
| Stock-based compensation                                                                                                           |       | 22                                  |       | 868 |   |
| Loss on impairment of long-lived assets                                                                                            |       | 32                                  |       | 2,139 |   |
| Equity in income of affiliates                                                                                                     |       | (51                                 | )          | (115 | ) |
| Change in fair value of derivative                                                                                                 |       | —                              |       | (5,924 | ) |
| Changes in operating assets and liabilities:                                                                                       |       |                                |       |   |   |
| Restricted cash                                                                                                                    |       | 1,421                               |       | — |   |
| Accounts receivable, net                                                                                                           |       | 1,691                               |       | 3,328 |   |
| Other current assets                                                                                                               |       | (506                                | )          | (16 | ) |
| Other assets                                                                                                                       |       | 31                                  |       | (204 | ) |
| Accounts payable                                                                                                                   |       | (6,517                              | )          | (153 | ) |
| Accrued payroll and benefits                                                                                                       |       | (1,099                              | )          | (1,677 | ) |
| Compensation to law firms                                                                                                          |       | (7,956                              | )          | (2,600 | ) |
| Accrued liabilities                                                                                                                |       | (676                                | )          | 6,995 |   |
| Deferred revenue                                                                                                                   |       | (856                                | )          | 435 |   |
| Other royalties payable                                                                                                            |       | (43                                 | )          | (352 | ) |
| Taxes payable                                                                                                                      |       | 44                                  |       | 562 |   |
| Other long-term liabilities                                                                                                        |       | (3                                  | )          | (7 | ) |
| Net cash used in operating activities                                                                                              |       | (19,460                             | )          | (10,703 | ) |
|                                                                                                                               |       |                                |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                                             |       |                                |       |   |   |
| Purchase of property and equipment                                                                                                 |       | (233                                | )          | (331 | ) |
| Purchase of available-for-sale securities                                                                                          |       | (8,224                              | )          | (53,520 | ) |
| Proceeds from available-for-sale securities                                                                                        |       | 20,904                              |       | 20,010 |   |
| Purchase of minority interest in Japanese subsidiary                                                                               |       | —                              |       | (209 | ) |
| Net cash provided by (used in) investing activities                                                                                |       | 12,447                              |       | (34,050 | ) |
|                                                                                                                               |       |                                |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                                             |       |                                |       |   |   |
| Proceeds from sale of common stock through employee  stock purchase program                                                        |       | 720                                 |       | 810 |   |
| Proceeds from exercise of common stock options                                                                                     |       | 235                                 |       | 591 |   |
| Offering costs incurred in connection with Series A-1  issuance                                                               |       | —                              |       | (211 | ) |
| Repurchase and retirement of Series A-1  convertible preferred stock                                                          |       | —                              |       | (13,000 | ) |
| Purchase of common stock                                                                                                           |       | —                              |       | (2,414 | ) |
| Net cash provided by (used in) financing activities                                                                                |       | 955                                 |       | (14,224 | ) |
|                                                                                                                               |       |                                |       |   |   |
| NET DECREASE IN  CASH AND CASH EQUIVALENTS                                                                                         |       | (6,058                              | )          | (58,977 | ) |
| EFFECT OF  FOREIGN EXCHANGE RATES ON CASH                                                                                          |       | (109                                | )          | 131 |   |
| CASH AND CASH  EQUIVALENTS, beginning of period                                                                                    |       | 12,693                              |       | 64,428 |   |
| CASH AND CASH  EQUIVALENTS, end of period                                                                                          |       | $                                   | 6,526      |   | $ | 5,582 |   |
|                                                                                                                               |       |                                |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                                                                 |       |                                |       |   |   |
|                                                                                                                               |       |                                |       |   |   |
| Cash paid for income taxes                                                                                                         |       | $                                   | 259        |   | $ | 652 |   |
|                                                                                                                               |       |                                |       |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING  ACTIVITIES:                                                         |       |                                |       |   |   |
|                                                                                                                               |       |                                |       |   |   |
| Increase in common stock subject to rescission                                                                                     |       | $                                   | 576        |   | $ | 557 |   |
|                                                                                                                               |       |                                |       |   |   |
| Dividend in connection with exchange of Series A-1  Convertible Preferred Stock for Series A Convertible Preferred Stock |       | $                                   | —     |   | $ | 6,305 |   |
|                                                                                                                               |       |                                |       |   |   |
| Accretion of dividends                                                                                                             |       | $                                   | —     |   | $ | 2,047 |   |
|                                                                                                                               |       |                                |       |   |   |
| Capital contribution in connection with repurchase  and cancellation of Series A-1 Convertible Preferred Stock                |       | $                                   | —     |   | $ | (15,475 | ) |

 

See accompanying notes to condensed consolidated financial statements.

 

6

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

 

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

## **(1) ORGANIZATIONAND DESCRIPTION OF BUSINESS**

 

The business of The SCOGroup, Inc. (the “Company”) focuses on marketing reliable, cost-effectiveUNIX software products and related services for the small-to-medium sized businessmarket, including replicated site franchisees of Fortune 1000 companies. In January 2003,the Company established its SCOsource business and launched its first ofseveral SCOsource initiatives to review and enforce its intellectual propertysurrounding the UNIX operating system. The Company acquired certainintellectual property rights surrounding UNIX and UNIX System V source codefrom The Santa Cruz Operation (now Tarantella, Inc.) in May 2001.

 

During the nine months ended July 31, 2005, theCompany used cash of $19,460,000 in its operating activities. The majority ofthis cash was used to pay accounts payable, accrued compensation to law firmsand liabilities related to the Company’s intellectual property litigation. Asof July 31, 2005, the Company had a total of $12,602,000 in cash and cashequivalents and available-for-sale securities and an additional $4,004,000 inrestricted cash, of which $3,579,000 is designated to be used as payments forexperts, consultants and other expenses in the SCO Litigation (as definedherein). As a result of the Engagement Agreement between the Company and thelaw firms representing it in its intellectual property rights, the Companyanticipates using cash of approximately $3,250,000 in the defense of itsintellectual property litigation during the three months ending October 31,2005. The Company expects that its UNIX business will generate sufficient cashin the year ending October 31, 2005 to cover the costs of its UNIXbusiness as well as its internal costs for its SCOsource initiatives andbelieves that it will have sufficient cash resources to fund its operationsthrough at least October 31, 2005.

 

In the event that cash required to fund operations andstrategic initiatives exceeds the Company’s current cash resources and cashgenerated from operating activities, the Company will be required to reducecosts or raise additional capital. The Company may not be able to reduce costsin a manner that does not impair its ability to maintain its UNIX business andpursue its SCOsource initiatives. The Company also may have difficulty raisingcapital. If additional equity financing is available, it may not be availableto the Company on attractive terms and may be dilutive to the Company’sexisting stockholders. In addition, if the Company’s stock price declines, itmay not be able to access the public equity markets on acceptable terms, if atall. The Company’s ability to effect acquisitions for stock would also beimpaired.

 

## **(2) SIGNIFICANTACCOUNTING POLICIES**

 

**Basis ofPresentation**

 

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. Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with U.S.generally accepted accounting principles have been condensed or omittedpursuant to SEC rules and regulations, although the Company believes that

 

7

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the following disclosures, when read in conjunctionwith the audited annual financial statements and the notes thereto included inthe Company’s most recent annual report on Form 10-K, are adequate to makethe information presented not misleading. Operating results for the three andnine months ended July 31, 2005 are not necessarily indicative of theresults that may be expected for the year ending October 31, 2005.

 

### **Use of Estimates in thePreparation 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 date ofthe financial statements and the reported amounts of revenue and expensesduring the reporting period. Actual results could differ from these estimates. TheCompany’s critical accounting policies and estimates include, among others,revenue recognition, allowances for doubtful accounts receivable, severance andexit costs, impairment of long-lived assets, and valuation allowances againstdeferred income tax assets.

 

### **Revenue Recognition**

 

The Company recognizes revenue in accordance withStatement of Position (“SOP”) 97-2, as modified by SOP 98-9. The Company’srevenue is primarily from three sources: (i) product license revenue,primarily from product sales to resellers, end users and original equipmentmanufacturers (“OEMs”); (ii) technical support service revenue, primarilyfrom providing technical support and consulting services to end users; and (iii)revenue from its SCOsource initiatives.

 

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. On occasion, the Company has revenue transactionsthat have multiple elements (such as software products, maintenance, technicalsupport services, and other services). For software agreements that havemultiple elements, the Company allocates revenue to each component of thecontract based on the relative fair value of the elements. The fair value ofeach element is based on vendor specific objective evidence (“VSOE”). VSOE isestablished when such elements are sold separately. The Company recognizesrevenue when the criteria for product revenue recognition set forth above havebeen met. If VSOE of all undelivered elements exists, but VSOE does not existfor one or more delivered elements, then revenue is recognized using theresidual method. Under the residual method, the fair value of the undeliveredelements is deferred and the remaining portion of the license fee is recognizedas revenue in the period when persuasive evidence of an arrangement is obtainedassuming all 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 technicalsupport services and consulting services is recognized as the related servicesare performed. Revenue for maintenance is recognized ratably over themaintenance period.

 

The Company considers an arrangement with paymentterms longer than the Company’s normal business practice, which do not extendbeyond 12 months, not to be fixed and determinable and revenue is recognizedwhen the fee becomes due. The Company typically provides stock rotation rightsfor sales made through its distribution channel and sales to distributors arerecognized upon shipment by the distributor to end users. For direct sales notthrough the Company’s distribution channel, sales are typically non-refundableand non-

 

8

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cancelable. The Company estimates its product returnsbased on historical experience and maintains an allowance for estimatedreturns, 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 Companyrecognizes revenue from SCOsource agreements when a signed contract exists, thefee is fixed and determinable, collection of the receivable is probable anddelivery has occurred. If the payment terms extend beyond the Company’s normalpayment terms, revenue is recognized as the payments become due.

 

**Pro Forma Fair Value of Stock-based Compensation**

 

The Company accounts for stock options issued todirectors, officers and employees under Accounting Principles Board (“APB”) No. 25,“Accounting for Stock Issued to Employees, and Related Interpretations.” UnderAPB No. 25, compensation expense is recognized if an option’s exerciseprice on the measurement date is below the fair market value of the Company’scommon stock. The compensation expense, if any, is amortized to expense overthe vesting period.

 

Statement of Financial Accounting Standards (“SFAS”) No. 148,“Accounting for Stock-Based Compensation,” requires pro forma informationregarding net income(loss) as if the Company had accounted for its stock options granted under thefair value method prescribed by SFAS No. 123, “Accounting for Stock-BasedCompensation.” The fair value for the Company’s stock options is estimated onthe date of grant using the Black-Scholes option-pricing model.

 

With respect to stock optionsand restricted stock awards granted and shares purchased pursuant to theCompany’s 2000 Employee Stock Purchase Plan (the “ESPP”) during the three andnine months ended July 31, 2005 and 2004, the assumptions used in theBlack-Scholes option-pricing model are as follows:

 
| ** **                         | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Risk-free  interest rate           |       | 4.1                                  | %          | 3.1                                 | %          | 3.7 | % | 2.8 | % |
| Expected  dividend yield           |       | 0.0                                  | %          | 0.0                                 | %          | 0.0 | % | 0.0 | % |
| Volatility                         |       | 47.1                                 | %          | 87.6                                | %          | 65.0 | % | 84.2 | % |
| Expected  exercise life (in years) |       | 2.7                                  |       | 2.9                                 |       | 2.7 |   | 3.0 |   |

 

9

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For purposes of the pro formadisclosure, the estimated fair value of stock options, restricted stock awardsand ESPP shares are amortized over the vesting period of the award. The followingis the pro forma disclosure and the related impact on net income (loss) tocommon stockholders and the net income (loss) to common stockholders per basicand diluted common share for the three and nine months ended July 31, 2005and 2004 (in thousands, except per share amounts):

 
| ** **                                                                     | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss) applicable to common stockholders:                           |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                    |       | $                                    | (2,372     | )                                   | $          | 7,501 |   | $ | (7,295 | ) | $ | (9,711 | ) |
| Add back: Stock-based compensation included in  reported net loss              |       | —                               |       | 270                                 |       | 22 |   | 868 |   |
| Deduct: Stock-based compensation under fair value  method                      |       | (569                                 | )          | (416                                | )          | (1,166 | ) | (1,699 | ) |
| Pro forma net income (loss) applicable to common  stockholders                 |       | $                                    | (2,941     | )                                   | $          | 7,355 |   | $ | (8,439 | ) | $ | (10,542 | ) |
| Net income (loss) applicable to common stockholders  per basic common share:   |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                    |       | $                                    | (0.13      | )                                   | $          | 0.49 |   | $ | (0.41 | ) | $ | (0.67 | ) |
| Pro forma                                                                      |       | $                                    | (0.16      | )                                   | $          | 0.48 |   | $ | (0.47 | ) | $ | (0.73 | ) |
| Net income (loss) applicable to common stockholders  per diluted common share: |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                    |       | $                                    | (0.13      | )                                   | $          | 0.38 |   | $ | (0.41 | ) | $ | (0.67 | ) |
| Pro forma                                                                      |       | $                                    | (0.16      | )                                   | $          | 0.37 |   | $ | (0.47 | ) | $ | (0.73 | ) |

 

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123R, “Share-Based Payment, anamendment of FASB Statements Nos. 123 and 95,” which requires themeasurement of all employee share-based payments to employees, including grantsof employee stock options, using a fair-value-based method and the recording ofsuch expense in the consolidated statements of operations and comprehensiveloss. The accounting provisions of SFAS No. 123R are effective forthe Company’s first fiscal year beginning after July 1, 2005, which willrequire the Company to adopt SFAS No. 123R for the three monthsending January 31, 2006.

 

The above disclosure for the three and nine monthsended July 31, 2005 and 2004 shows the pro forma net loss and net loss percommon share as if the Company had used a fair-value-based method similar tothe methods required under SFAS No. 123R to measure compensationexpense for employee stock incentive awards. The Company is in the process ofdetermining whether the adoption of SFAS No. 123R will result infuture amounts that are similar to the pro forma disclosure above underSFAS No. 123, and adoption of SFAS No. 123R could have amaterial impact on the Company’s results of operations.

 

**Cash and Cash Equivalents**

 

The Company considers all investments purchased withoriginal maturities of three or fewer months to be cash equivalents. Cashequivalents were $2,515,000 and $2,633,000 as of July 31, 2005 and October 31,2004, respectively. Cash was $4,011,000 and $10,060,000 as of July 31,2005 and October 31, 2004, respectively.

 

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**Available-for-Sale Securities**

 

Available-for-sale securities are recorded at fairmarket value, based on quoted market prices, and unrealized gains and lossesare recorded as a component of accumulated other comprehensive income. Realizedgains and losses, which are calculated based on the specific-identificationmethod, are recorded in operations as incurred.

 

Available-for-sale securities totaled $6,076,000 as ofJuly 31, 2005 and consisted of government agency securities and corporatenotes. Any available-for-sale securities in an unrealized loss position as of July 31,2005 were not impaired at acquisition and the decline in fair value isprimarily attributable to interest rate fluctuations. A decline in the marketvalue of any available-for-sale security below cost that is deemed other thantemporary results in a charge to earnings and establishes a new basis for thesecurity.

 

**Earnings per Share**

 

Basic net income (loss) per common share (“Basic EPS”)is computed by dividing net income (loss) by the weighted average number ofcommon shares outstanding. Diluted net income (loss) per common share (“DilutedEPS”) is computed by dividing net income (loss) by the sum of the weightedaverage number of common shares outstanding and the dilutive potential commonshare equivalents then outstanding. Potential common share equivalents consistof the weighted average of shares issuable upon the exercise of outstandingstock options, restricted stock awards, warrants to acquire common stock andpreferred stock convertible into common shares. If dilutive, the Companycomputes Diluted EPS using the treasury stock method.

 

The following table is a reconciliation of thenumerator and denominator of Basic EPS to the numerator and denominator ofDiluted EPS for the three and nine months ended July 31, 2005 and 2004 (inthousands, except per share amounts):

 
| ** **                                                        | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                        | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                              |       |                                 |       |                                |       |   |   |   |   |
| Numerator:                                                        |       |                                 |       |                                |       |   |   |   |   |
| Net income attributable (loss applicable) to common  stockholders |       | $                                    | (2,372     | )                                   | $          | 7,501 |   | $ | (7,295 | ) | $ | (9,711 | ) |
| Denominator:                                                      |       |                                 |       |                                |       |   |   |   |   |
| Weighted average common basic shares outstanding                  |       | 17,993                               |       | 15,242                              |       | 17,885 |   | 14,389 |   |
| Convertible preferred stock                                       |       | —                               |       | 2,657                               |       | — |   | — |   |
| Stock options                                                     |       | —                               |       | 1,740                               |       | — |   | — |   |
| Restricted stock                                                  |       | —                               |       | 125                                 |       | — |   | — |   |
| Warrants                                                          |       | —                               |       | 148                                 |       | — |   | — |   |
| Weighted average diluted common shares outstanding                |       | 17,993                               |       | 19,912                              |       | 17,885 |   | 14,389 |   |
| Basic EPS                                                         |       | $                                    | (0.13      | )                                   | $          | 0.49 |   | $ | (0.41 | ) | $ | (0.67 | ) |
| Diluted EPS                                                       |       | $                                    | (0.13      | )                                   | $          | 0.38 |   | $ | (0.41 | ) | $ | (0.67 | ) |
|                                                              |       |                                 |       |                                |       |   |   |   |   |
| Excluded anti-dilutive common share equivalents                   |       | 3,982                                |       | 998                                 |       | 3,982 |   | 397 |   |

 

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The excluded anti-dilutive common share equivalentsare not included in the computation of Diluted EPS as their inclusion would beanti-dilutive to the net loss per common share.

 

**Income Taxes**

 

In October 2004, the American Jobs Creation Act(the “AJCA”) was signed into law. The AJCA includes a deduction of 85 percentof certain foreign earnings that are repatriated in the AJCA. The Company mayelect to apply this provision to qualifying earnings repatriations in its yearending October 31, 2005. The Company does not believe that it will haveany foreign earnings repatriation under the AJCA during the year ending October 31,2005.

 

The Internal Revenue Code contains provisions thatlikely could reduce or limit the availability and utilization of net operatingloss carry-forwards if certain changes in ownership have taken place or willtake place. Ownership changes have occurred and utilization of the Company’snet operating loss carry-forwards may be limited pursuant to Internal RevenueCode Section 382 as a result of these ownership changes.

 

**Reclassifications**

 

Certain reclassifications have been made to priorperiods’ amounts to conform to the current period presentation. Thereclassifications had no effect on net income (loss) for the prior periods.

 

**(3) INTANGIBLE ASSETS**

 

The following table shows the activity related toamortizable intangible assets for the nine months ended July 31, 2005 aswell as the remaining unamortized balances as of July 31, 2005 (inthousands):

 

| ** **                      | ** ** | **As of  October 31, 2004** | ** ** | **Nine Months Ended  July 31, 2005** | ** ** | **As of  July 31, 2005** | ** ** |
|---------------------------------|------------|----------------------------------|------------|-------------------------------------------|------------|-------------------------------|------------|
| ** **                      | ** ** | ** **                       | ** ** | **Amortization**                          | ** ** | **Impairment**                | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Net Book Value**               | ** ** | **Expense**                               | ** ** | **Loss**                      | ** ** | **Net Book Value** | ** ** |
| Amortizable  intangible assets: |       |                             |       |                                      |       |                          |       |   |   |
| Distribution/reseller channel   |       | $                                | 4,636      |                                      | $          | (1,739                        | )          | $ | — |   | $ | 2,897 |   |
| Acquired technology             |       | 673                              |       | (252                                      | )          | —                        |       | 421 |   |
| Trade name                      |       | 104                              |       | (39                                       | )          | —                        |       | 65 |   |
| Total intangible assets         |       | $                                | 5,413      |                                      | $          | (2,030                        | )          | $ | — |   | $ | 3,383 |   |

 

Of the $2,030,000 in amortization expense, $1,779,000was classified as amortization of intangible assets in operating expenses andthe remaining $251,000 was classified as cost of SCOsource licensing revenue.

 

**(4) INVESTMENTS**

 

**Sale of Troll Tech Shares**

 

In December 1999, theCompany and The Canopy Group, Inc. (“Canopy”), a former holder of theCompany’s common stock, entered into an agreement with Troll Tech AS (“TrollTech”) and its stockholders. Pursuant to the agreement, the Company acquiredshares of Troll Tech in exchange for shares of the Company, and Canopy acquiredshares of Troll Tech in exchange for $1,000,000. The Company recorded itsinvestment in Troll Tech’s common stock at $400,000, based on the cash priceper share paid by Canopy. The Company determined that the cash price per sharepaid by Canopy was the most reliable evidence of the value of Troll Tech’s

 

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common stock. During theyear ended October 31, 2001, management determined that the carrying valueof the investment in Troll Tech of $400,000 would most likely not berecoverable, and the investment was written down to $0.

 

During the three monthsended April 30, 2005, the Company received notice from Troll Tech that athird-party investor was interested in acquiring the Company’s shares of TrollTech. On March 14, 2005, the Company received proceeds of $779,100 for theTroll Tech shares. The Company accounted for the sale and proceeds of the TrollTech shares in the three months ended April 30, 2005 when it received theproceeds from the shares. All amounts related to the book value of the shareshad been written off during the year ended October 31, 2001, and theCompany recorded the proceeds received as a component of other income in itsstatement of operations and comprehensive loss for the nine months ended July 31,2005.

 

**(5) COMMITMENTS AND CONTINGENCIES**

 

**Litigation**

 

The following includesupdated information relating to certain of the Company’s material legalproceedings as previously reported in the Company’s annual report on Form 10-Kfor the year ended October 31, 2004, and previously updated in the Company’squarterly reports on Form 10-Q for the three-month periods ended January 31,2005 and April 30, 2005.

 

*IBM Corporation*

 

On or about March 6,2003, the Company filed a complaint against IBM Corporation (“IBM”). Thisaction is pending in the United States District Court for the District of Utah,under the title The SCO Group, Inc. v. International Business MachinesCorporation, Civil No. 2:03CV0294. This action includes, among otherthings, Company claims against IBM for breach of contract, copyrightinfringement, tortious interference, and unfair competition relating to IBM’salleged use and distribution of information concerning the UNIX source code andderivative works in connection with its efforts to promote the Linux operatingsystem. IBM has responded to the Company’s claims and made counterclaimsagainst the Company.

 

Following a hearing on October 19, 2004, on January 19,2005, the United States Magistrate Judge overseeing discovery in the caseissued an order granting in part and denying in part discovery applicationsthat the Company had made. The Court ordered IBM to produce much of the information,including source code, revision information, and programmer- contributioninformation, that the Company had previously requested. The Court also struckthe Amended Scheduling Order and directed the parties to submit a proposedamended scheduling order to the Court, which the parties did. The DistrictCourt heard argument on the proposed schedules on April 21, 2005. On July 1,2005, the Court issued a revised scheduling order establishing, among otherthings, discovery and motion deadlines over the next 18 months with a five-weekjury trial to commence on February 26, 2007.

 

In response to theMagistrate Court’s Order, IBM filed on February 11, 2005, a Motion forReconsideration of the portion of the January 19 Order that required IBMto produce programmer-contribution information for 3,000 people. IBM alsofiled, on March 9, 2005, a Motion for a 45-day Extension of Time to Complywith the Court’s January 19 Order as it applies to materials that were notthe subject of IBM’s above-referenced Motion for Reconsideration. On March 16,2005, the Court granted the extension and entered an order requiring IBM toproduce those materials by May 3, 2005. With respect to the materialscovered by IBM’s Motion for Reconsideration, the Court granted IBM’s request tostay its discovery obligations pending the Court’s resolution of its motion.

 

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On April 19, 2005,the Magistrate Court ruled on IBM’s reconsideration motion. The Court declinedto strike its prior requirement that IBM produce documents from the files ofthe 3,000 individuals who made the most contributions and changes to thedevelopment of AIX and Dynix. The Court reiterated its requirement that IBMproduce programmer’s notes, design documents, white papers, comments and notes,contact information, specific changes made to code, and all relevantnon-privileged documents from the files of the 100 individuals who made themost contributions and changes to the development of AIX and Dynix; ordered IBMto provide a privilege log for any documents withheld from the files of those100 individuals; and required IBM to comply within 90 days. The Court deferredthe remainder of IBM’s required production pending the Company’s review of theabove-described discovery. The Court also reiterated that IBM is required toproduce all non-public Linux contribution information and directed IBM toproduce all such information within 75 days.

 

On February 9, 2005,the United States District Judge ruled on several pending dispositive motions. TheCourt denied the three motions for partial summary judgment that IBM had filedon the Company’s contract claims, on IBM’s eighth counterclaim for copyrightinfringement, and on IBM’s tenth counterclaim for a declaration of non-infringementof the Company’s copyrights. The Court denied each of those motions withoutprejudice to IBM’s renewing or refiling the motions after discovery iscomplete. The Court also denied the Company’s motion to stay or dismiss IBM’stenth counterclaim. The Court ordered that no further dispositive motions couldbe filed until the close of discovery, except by stipulation of the parties,and vacated its prior order, dated September 30, 2004, to the extent thatorder had granted permission to file dispositive motions before the close ofdiscovery.

 

On January 12, 2005,the Company filed its Motion to Compel IBM to produce IBM CEO Samuel J.Palmisano for Deposition. The Court heard argument on that motion on April 21,2005. On July 1, 2005, the Court issued an order granting the Company’smotion and ordered IBM to produce Mr. Palmisano for a four-hour depositionin New York. The Court found that Mr. Palmisano could have unique personalknowledge related to the claims in the case.

 

The parties have also nowfully briefed the Company’s December 23, 2004 Renewed Motion to CompelDiscovery, which seeks to compel IBM’s compliance with prior Court ordersrelating to IBM’s obligation (1) to produce all documents pertaining toLinux from the files of high-level IBM executives and board members; and (2) toproduce witnesses to testify on several topics in two deposition notices thatSCO has served on IBM. The Court has not set a hearing date for this motion.

 

On September 6,2005, the Company filed a renewed motion to compel IBM to produce informationrelating to IBM’s work on the source code that IBM contributed to Linux wheresuch information is in IBM’s hands and not publicly available.

 

In addition to thematerials that have been publicly filed with the Court, certain information hasbeen filed under seal in accordance with the protective order entered in thecase. On November 30, 2004, a third party moved to intervene in the casefor the purpose of challenging the sealing of certain documents filed with theCourt, and additional groups subsequently joined in that motion. Followingargument on April 26, 2005, by Order dated April 28, 2005, the Courtdenied the intervention motion. In its Order, the Court set forth variousprocedures to minimize the risk that documents would be improperly filed underseal. The parties have since directed the Clerk of the Court to unseal numerouspreviously sealed filings.

 

The Company also filed amotion for leave to file a third amended complaint in order to assert anadditional copyright claim against IBM in the case. The Court heard argument onthat fully briefed motion on April 21, 2005, and took the matter underadvisement. In its July 1 order, the Court denied the Company’s motion. TheCourt first allowed IBM to narrow the scope of its

 

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Ninth Counterclaim, and having done soconcluded that SCO’s proposed new claim would expand the litigation and delayits resolution. The Court also opined that it appears that the Company or itspredecessor-in-interest either knew or should have known about the conduct atissue in the new claim before the Company filed its original Complaint. TheCompany therefore will not pursue additional copyright remedies in this caseregarding IBM’s alleged misuse of the Company’s code in its AIX product as setforth in the proposed amended complaint. The Company has explained in briefingand argument before the Court, however, that the predicate facts of theproposed copyright claim are already in the case as part of other claims.

 

Discovery is continuingin the case and the Company is reviewing that discovery.

 

*Red Hat, Inc.*

 

On August 4, 2003, Red Hat, Inc. (“Red Hat”)filed a complaint against the Company. The action is pending in the UnitedStates District Court for the District of Delaware under the case caption RedHat, Inc. v. The SCO Group, Inc., Civil No. 03-772. Red Hatasserts that the Linux operating system does not infringe on the Company’s UNIXintellectual property rights and seeks a declaratory judgment fornon-infringement of copyrights and no misappropriation of trade secrets. Inaddition, Red Hat claims the Company has engaged in false advertising inviolation of the Lanham Act, deceptive trade practices, unfair competition,tortious interference with prospective business opportunities, trade libel anddisparagement. On April 6, 2004, the court denied the Company’s motion todismiss this case; however, the court stayed the case and requested statusreports every 90 days regarding the case against IBM. Red Hat filed a motionfor reconsideration, which the Court denied on March 31, 2005. The Companyintends to vigorously defend this action. In the event the stay is lifted andRed Hat is allowed to pursue its claims, the Company will likely assertcounterclaims against Red Hat.

 

*Novell, Inc.*

 

On January 20, 2004, the Company filed suitin Utah state court against Novell, Inc. (“Novell”) for slander of titleseeking relief for its alleged bad faith effort to interfere with the Company’sownership of copyrights related to its UNIX source code and derivative worksand its UnixWare product. The case, after removal to federal court, is pendingin the United States District Court for the District of Utah under the captionThe SCO Group, Inc. v. Novell, Inc., Civil No. 2:04CV00139. Inthe lawsuit, the Company requested preliminary and permanent injunctive reliefas well as damages. Through these claims, the Company seeks to require Novellto assign to the Company all copyrights that it believes Novell has wrongfully registered,prevent Novell from representing any ownership interest in those copyrights andrequire Novell to retract or withdraw all representations it has made regardingits purported ownership of those copyrights.

 

Novell has filed a second motion to dismiss claiming,among other things, that Novell’s false statements were not uttered with maliceand are privileged under the law. The Court heard the argument on the motion onMay 25, 2005. On June 27, 2005, the Court issued an order denyingNovell’s motion. On July 29, 2005, Novell filed its Answer andCounterclaims against the Company, asserting counterclaims for the Company’salleged breaches of the Asset Purchase Agreement between Novell and the Company’spredecessor-in-interest, The Santa Cruz Operation, Inc. (now Tarantella, Inc.),for slander of title, restitution/unjust enrichment, and accounting, and fordeclaratory relief regarding Novell’s alleged rights under the Asset PurchaseAgreement. By stipulation of the parties and approval of the Court, the Company’sresponse to Novell’s Answer and Counterclaims was due and filed on September 12,2005.

 

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*DaimlerChrysler Corporation*

 

On or about March 3, 2004, the Company broughtsuit against DaimlerChrysler Corporation (“DaimlerChrysler”) for its allegedviolations of its UNIX license agreement with the Company. The lawsuit allegesthat DaimlerChrysler breached its UNIX software agreement by failing to providean adequate or timely certification of its compliance with that agreement asthe Company requested. The lawsuit, filed in Oakland County Circuit Court inthe State of Michigan, requests the court to declare that DaimlerChrysler hasviolated the certification requirements of its UNIX software agreement,permanently enjoin DaimlerChrysler from further violations of the UNIX softwareagreement, issue a mandatory injunction requiring DaimlerChrysler to remedy theeffects of its past violations of the UNIX software agreement and award theCompany damages in an amount to be determined at trial together with costs,attorneys’ fees and any such other or different relief that the court may deemto be equitable and just.

 

In response to DaimlerChrysler’s motion to dismiss,the court granted DaimlerChrysler’s motion as to the substance ofDaimlerChrysler’s certification, but denied the motion as to whether thecertification was timely. Based on this ruling, the Company filed a motion tostay the case pending the clarification of certain issues in the IBMlitigation. The court denied the motion to stay. Based on a stipulation of theparties, however, the court signed an order of dismissal without prejudice. Theappellate court has dismissed the Company’s appeal of the July 21, 2004ruling finding that the order was not a final, appealable order; the Company isevaluating its options regarding the appellate court’s ruling.

 

*AutoZone, Inc.*

 

On or about March 2, 2004, the Company broughtsuit against AutoZone, Inc. (“AutoZone”) for its alleged violations of theCompany’s UNIX copyrights through its use of Linux. The lawsuit allegescopyright infringement by AutoZone by, among other things, running versions ofthe Linux operating system that contain proprietary material from UNIX SystemV. The lawsuit, filed in United States District Court in Nevada, requestsinjunctive relief against AutoZone’s further use or copying of any part of theCompany’s copyrighted materials and also requests damages as a result ofAutoZone’s infringement in an amount to be proven at trial. In response toAutoZone’s motion to transfer the case to Tennessee or stay the case, thefederal court in Nevada granted AutoZone’s motion to stay the case, with 90-daystatus reports to the court, and denied without prejudice AutoZone’s motion totransfer the case to Tennessee. The federal court allowed the parties to takelimited expedited discovery relating to the issue of preliminary injunctiverelief which discovery was concluded in May 2005.

 

TheCompany has concluded the initial discovery allowed by the court and filed itsreport with the court on May 27, 2005. Contrary to AutoZone’s ownstatements to the court, the Company found through discovery, includingdepositions and other admissions of AutoZone, many instances of copying ofprograms containing SCO OpenServer code. AutoZone has represented that it hasnow removed all of the SCO code and proprietary information it copied or usedin its migration to Red Hat Linux. Because AutoZone represents it has removedor otherwise is not using SCO code and proprietary information, the Companycurrently does not intend to move for a preliminary injunction. AutoZone doesnot admit that it violated the Company’s rights or caused the Company damage inthat migration process, which are still points of dispute between the parties. Giventhe stay issued by the court in the case, the Company reserves the right topursue infringement and damages in the future based on these issues and otherissues stayed by the court.

 

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*IPO Class Action Matter*

 

The Company is an issuerdefendant in a series of class action lawsuits involving over 300 issuers thathave been consolidated under In re Initial Public Offering SecuritiesLitigation, 21 MC 92 (SAS). The consolidated complaint alleges, among otherthings, certain improprieties regarding the underwriters’ conduct during theCompany’s initial public offering and the failure to disclose such conduct inthe registration statement in violation of the Securities Act of 1933, asamended.

 

The plaintiffs, theissuers and the insurance companies have negotiated an agreement to settle thedispute between the plaintiffs and the issuers. All parties, including theplaintiffs, issuers and insurance companies, have executed this settlementagreement and the settlement agreement has been submitted to the court forapproval. If the settlement agreement is approved by the court, and if nocross-claims, counterclaims or third-party claims are later asserted, thisaction will be dismissed with respect to the Company and its directors.

 

The Company has notifiedits underwriters and insurance companies of the existence of the claims. Managementbelieves, after consultation with legal counsel, that the ultimate outcome ofthis matter will not have a material adverse effect on the Company’s results ofoperations or financial position and will not exceed the $200,000 self-insuredretention already paid or accrued by the Company.

 

*Other Matters*

 

In April 2003, aformer Indian distributor of the Company filed a claim in India, requestingsummary judgment for payment of $1,428,000, and an order that the Company tradein India only through the distributor and/or give a security deposit until theclaim is paid. The distributor claims that the Company is responsible to repurchasecertain software products and to reimburse the distributor for certain otheroperating costs. The distributor additionally requested that the Indian courtsgrant interim relief in the form of attachment of local assets. Management doesnot believe that the Company is responsible to reimburse the distributor forany operating costs and also believes that the return rights related to anyremaining inventory have lapsed. Discovery has commenced and hearings on therequests for interim relief have been held and are ongoing. The Company intendsto vigorously defend this action.

 

Pursuit and defense ofthe above-mentioned matters will be costly, and management expects the costsfor legal fees and related expenses will be substantial. The ultimate outcomeor potential effect on the Company’s results of operations or financialposition of the above-mentioned matters is not currently known or determinable.

 

The Company is a party tocertain other legal proceedings arising in the ordinary course of business. Managementbelieves, after consultation with legal counsel, that the ultimate outcome ofsuch legal proceedings will not have a material adverse effect on the Company’sresults of operations or financial position.

 

**Grants of Unregistered Stock Options; PotentialInterest and Penalties Related to Rescission Rights**

 

The Company believes certain shares and optionsgranted under its 1998 Stock Option Plan, 1999 Omnibus Stock Option Plan, theESPP, 2002 Omnibus Stock Incentive Plan, and 2004 Omnibus Stock Incentive Plan(collectively, the “Equity Compensation Plans”) were issued without complyingwith registration or qualification requirements under federal securities lawsand the securities laws of California, Utah and possibly other states. As aresult, certain plan participants have a right to rescind their purchases ofshares under the Equity Compensation Plans or recover damages if they no longerown the shares or hold unexercised options, subject to applicable statutes oflimitations. Additionally, regulatory authorities may require the Company

 

17

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to pay fines or impose other sanctions. On July 28,2005, the Company filed a registration statement on Form S-1 with the SECto register the repurchase by the Company of approximately 313,000 sharesissued under the ESPP from current or former participants in the ESPP. As ofthe date of the filing of this quarterly report on Form 10-Q, the SEC hasnot declared the Form S-1 registration statement effective.

 

The Company believes certain of its stock optiongrants made since February 2003 may have also violated applicablesecurities laws in California, Georgia and possibly other states even thoughholders have not exercised such options. Because the options in question havenot been exercised, no amounts are recorded in permanent equity. The Companyhas not included in its proposed registration statement on Form S-1 therepurchase of shares to be issued upon the exercise of these stock options. Sinceany loss may be considered reasonably possible but not estimable, the Companyhas not recorded a liability for this contingency.

 

The Company may also be required to pay interest andpenalties up to statutory limits in connection with plan participants makingrescission claims. The Company believes that it is reasonably possible that itmay be required to pay interest and penalties, but it is not able to estimatean amount.

 

**(6) COMMONSTOCK SUBJECT TO RESCISSION**

 

As described in Note 5, certain participants in theEquity Compensation Plans have a right to rescind their purchases of sharesunder the Equity Compensation Plans or recover damages if they no longer ownthe shares or hold unexercised options, subject to applicable statutes oflimitations.

 

Accounting Series Release (“ASR”) No. 268and Emerging Issues Task Force (“EITF”) Topic D-98 require that stock subjectto rescission or redemption requirements outside the control of the Company beclassified outside of permanent equity. Theexercise of the rescission right is at the holders’ discretion, but exercise ofthat right may depend in part on the fair value of the Company’s common stock,which is outside of the Company’s and the holders’ control. Consequently,common stock subject to rescission is classified as temporary equity. If theCompany’s rescission offer becomes effective and is accepted by planparticipants holding shares acquired under the ESPP or otherwise entitled torecover damages from the Company in respect of such shares they have sold, orother plan participants otherwise make rescission claims against the Company,the Company could be required to make aggregate payments to all such planparticipants of up to $1,104,000, excluding interest and other possible fees,based upon shares outstanding under the Equity Compensation Plans as of July 31,2005.

 

Upon the completion of the Company’s rescission offeror if plan participants otherwise exercise rescission rights, any amounts theCompany may pay to plan participants, excluding interest and other possible charges,will be deducted from common stock subject to rescission, and, in the event aplan participant declines a rescission offer or otherwise is determined to nolonger have a rescission right, any remaining amounts recorded to common stocksubject to rescission will be recorded as permanent equity.

 

**(7) STOCKHOLDERS’ EQUITY**

 

**Stock Options**

 

During the three and nine months ended July 31,2005, the Company granted options to purchase 321,000 and 952,000 shares ofcommon stock with an average exercise price of $3.93 and $4.44, respectively,per share. None of these stock options were granted with an exercise pricebelow the quoted market price on the date of grant. During the three and ninemonths ended July 31, 2005, options to purchase approximately 17,000 and159,000 shares of common stock were

 

18

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exercised with an average exercise price of $1.79 and$1.48, respectively, per share. As of July 31, 2005, there wereapproximately 3,722,000 stock options outstanding with a weighted averageexercise price of $4.25 per share.

 

**Change in Control Agreements**

 

On December 10, 2004, the Company entered into Changein Control Agreements (each, a “Change in Control Agreement”) with thefollowing executive officers: Darl C. McBride; Bert B. Young; ChristopherSontag; Jeff F. Hunsaker; and Ryan E. Tibbitts (each, an “Officer”). EachChange in Control Agreement is effective as of December 10, 2004.

 

Pursuant to the terms of each Change inControl Agreement, the Officer agrees that he or she will not voluntarily leavethe employ of the Company in the event any individual, corporation,partnership, company or other entity takes certain steps to effect a Change inControl (as defined in the Change in Control Agreement) of the Company, untilthe attempt to effect a Change in Control has terminated, or until a Change inControl occurs.

 

If the Officer is still employed by theCompany when a Change in Control occurs, any stock, stock option or restrictedstock granted to the Officer by the Company that would have become vested uponcontinued employment by the Officer shall immediately vest in full and becomeexercisable notwithstanding any provision to the contrary of such grant andshall remain exercisable until it expires or terminates in accordance with itsterms. Each Officer shall be solely responsible for any taxes that arise orbecome due pursuant to the acceleration of vesting that occurs pursuant to theChange in Control Agreement.

 

The adoption of the Change in ControlAgreements allows for accelerated vesting on all outstanding shares of commonstock and represents a modification to the underlying stock option award. Inaccordance with FASB Interpretation No. 44 “Accounting for CertainTransactions Involving Stock Compensation,” the Company has calculated thetotal intrinsic value of the awards of $2,012,000, which represents the valueof the awards that were subject to the acceleration. During the three and ninemonths ended July 31, 2005, this amount had not been recorded in thecondensed consolidated financial statements as an event to trigger theacceleration was not considered probable.

 

**Stockholder Rights Plan**

 

On August 10, 2004, theCompany’s Board of Directors adopted a Stockholder Rights Plan (the “RightsPlan”) designed to deter coercive takeover tactics, including accumulation ofthe Company’s shares in the open market or through private transactions and toprevent an acquirer from gaining control of the Company without offering a fairprice to all of the Company’s stockholders.

 

Under theterms of the Rights Plan, Series A Junior Participating Preferred Stockpurchase rights were distributed as a dividend at the rate of one right foreach share of common stock of the Company held by stockholders of record as ofthe close of business on August 30, 2004, and will be distributed toholders of subsequently issued shares of common stock. The Rights Plan would betriggered if a person or group acquired beneficial ownership of 15 percent ormore of the Company’s common stock other than pursuant to a board-approvedtender or exchange offer or commences, or publicly announces an intention tocommence, a tender or exchange offer upon consummation of which such person orgroup would beneficially own 15 percent or more of the Company’s common stock. Thevalue of the purchase rights is immaterial as of July 31, 2005.

 

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**Transfer of Stock Ownership by TheCanopy Group to Ralph J. Yarro III**

 

Effective March 11, 2005, The Canopy Group (“Canopy”)transferred all of its shares of the Company’s common stock to Ralph J. YarroIII, the Chairman of the Company’s Board of Directors.

 

**(8) CONCENTRATIONOF RISK**

 

As of July 31, 2005 and October 31, 2004,the Company had no customers who made up more than 10 percent of the endingaccounts receivable balance.

 

During the three and nine months ended July 31,2005 and 2004, no single customer accounted for more than 10 percent of totalrevenue.

 

**(9) RELATED PARTY TRANSACTIONS**

 

As of October 31, 2004, Canopy ownedapproximately 31 percent of the Company’s issued and outstanding common stock. Asdescribed in Note 7, on March 11, 2005, Canopy transferred all of itsshares of common stock to Ralph J. Yarro III.

 

On April 30, 2003, the Company and Center 7, Inc.(“C7”) entered into a Marketing and Distribution Master Agreement (the “MarketingAgreement”) and an Assignment Agreement. On October 2, 2003, C7 assignedthe Assignment Agreement to Vintela, Inc. (“Vintela”) and Vintela and theCompany entered into a new marketing agreement (the “Vintela Agreement”). BothC7 and Vintela are majority owned by Canopy. Under the Vintela Agreement, theCompany was appointed as a worldwide distributor for Vintela products toco-brand, market and distribute these products.

 

Under the Assignment Agreement, the Company assignedthe copyright applications, patents and contracts related to Volution Manager,Volution Authentication, Volution Online and Volution Manager Update Service(collectively, the “Assigned Software”). As consideration for this assignment,C7 issued, and Vintela assumed, a $500,000 non-recourse promissory note payableto the Company, secured by the Assigned Software. This note was originally dueon April 30, 2005 with interest payable at a rate of one percent above theprime rate as reported in the Wall Street Journal.

 

In late November 2004, the Company entered intodiscussions with Vintela with respect to the cancellation of the MarketingAgreement and repayment of the Note. It was later agreed that once Vintela hadreceived funding from an outside third party, the Company would forego anyinterest charges on the promissory note in return for an immediate payment ofthe $500,000. On December 9, 2004, the Company received the $500,000payment from Vintela and forgave the outstanding interest charges associatedwith the promissory note.

 

At the time the promissory note was executed, theCompany had no recorded basis in the Assigned Software. Because the transfer ofthe Assigned Software was to a related party in exchange for a promissory noteand there was substantial doubt concerning the ability of C7 to repay the debtas they were not profitable and being funded by Canopy, no gain was recognizedby the Company until payment was received on December 9, 2004. The Companyrecorded the $500,000 received as a component of other income in its statementof operations and comprehensive loss for the nine months ended July 31,2005.

 

**(10) SEGMENT INFORMATION**

 

The Company’s resources are allocated and operatingresults managed to the operating income (loss) level for each of the Company’ssegments: UNIX and SCOsource. Both segments

 

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are based on the Company’s UNIX intellectual property.The UNIX business sells and distributes UNIX products and services through anextensive distribution channel and to corporate end-users and the SCOsourcebusness enforces and protects the Company’s UNIX intellectual property.

 

Segment disclosures for the Company are as follows forthe three and nine months ended July 31, 2005 (in thousands):

 
| ** **                    | ** ** | **Three Months Ended July 31,  2005** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **UNIX**                                   | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                          |       |                                       |       |   |   |   |   |
| Revenue                       |       | $                                          | 9,321      |   | $ | 32 |   | $ | 9,353 |   |
| Cost of revenue               |       | 1,395                                      |       | 3,085 |   | 4,480 |   |
| Gross margin (deficit)        |       | 7,926                                      |       | (3,053 | ) | 4,873 |   |
| Sales and  marketing          |       | 2,935                                      |       | — |   | 2,935 |   |
| Research and  development     |       | 1,843                                      |       | 97 |   | 1,940 |   |
| General and  administrative   |       | 1,556                                      |       | 91 |   | 1,647 |   |
| Other                         |       | 593                                        |       | — |   | 593 |   |
| Total operating expenses      |       | 6,927                                      |       | 188 |   | 7,115 |   |
| Income (loss) from operations |       | $                                          | 999        |   | $ | (3,241 | ) | $ | (2,242 | ) |

 
| ** **                    | ** ** | **Three Months Ended July 31,  2004** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **UNIX**                                   | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                          |       |                                       |       |   |   |   |   |
| Revenue                       |       | $                                          | 10,527     |   | $ | 678 |   | $ | 11,205 |   |
| Cost of revenue               |       | 1,619                                      |       | 7,396 |   | 9,015 |   |
| Gross margin (deficit)        |       | 8,908                                      |       | (6,718 | ) | 2,190 |   |
| Sales and  marketing          |       | 3,740                                      |       | 493 |   | 4,233 |   |
| Research and  development     |       | 2,361                                      |       | 231 |   | 2,592 |   |
| General and  administrative   |       | 1,761                                      |       | 128 |   | 1,889 |   |
| Other                         |       | 863                                        |       | — |   | 863 |   |
| Total operating expenses      |       | 8,725                                      |       | 852 |   | 9,577 |   |
| Income (loss) from operations |       | $                                          | 183        |   | $ | (7,570 | ) | $ | (7,387 | ) |

 

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| ** **                    | ** ** | **Nine Months Ended July 31,  2005** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
| ** **                    | ** ** | **UNIX**                                  | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                          |       |                                      |       |   |   |   |   |
| Revenue                       |       | $                                         | 27,344     |   | $ | 132 |   | $ | 27,476 |   |
| Cost of revenue               |       | 4,097                                     |       | 9,467 |   | 13,564 |   |
| Gross margin (deficit)        |       | 23,247                                    |       | (9,335 | ) | 13,912 |   |
| Sales and  marketing          |       | 8,681                                     |       | 154 |   | 8,835 |   |
| Research and  development     |       | 5,838                                     |       | 299 |   | 6,137 |   |
| General and  administrative   |       | 5,094                                     |       | 352 |   | 5,446 |   |
| Other                         |       | 1,801                                     |       | — |   | 1,801 |   |
| Total operating expenses      |       | 21,414                                    |       | 805 |   | 22,219 |   |
| Income (loss) from operations |       | $                                         | 1,833      |   | $ | (10,140 | ) | $ | (8,307 | ) |

 
| ** **                  | ** ** | **Nine Months Ended July 31,  2004** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **UNIX**                                  | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                        |       |                                      |       |   |   |   |   |
| Revenue                     |       | $                                         | 32,025     |   | $ | 709 |   | $ | 32,734 |   |
| Cost of revenue             |       | 5,637                                     |       | 15,486 |   | 21,123 |   |
| Gross margin (deficit)      |       | 26,388                                    |       | (14,777 | ) | 11,611 |   |
| Sales and  marketing        |       | 12,868                                    |       | 1,084 |   | 13,952 |   |
| Research and  development   |       | 7,838                                     |       | 329 |   | 8,167 |   |
| General and  administrative |       | 5,643                                     |       | 150 |   | 5,793 |   |
| Other                       |       | 5,662                                     |       | — |   | 5,662 |   |
| Total operating expenses    |       | 32,011                                    |       | 1,563 |   | 33,574 |   |
| Loss from operations        |       | $                                         | (5,623     | ) | $ | (16,340 | ) | $ | (21,963 | ) |

 

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 July 31,2005 and October 31, 2004 (in thousands):

 
| ** **                             | ** ** | ** ** | ** ** | **July 31,  2005** | ** ** | **October 31,  2004** | ** ** |
|----------------------------------------|------------|------------|------------|-------------------------|------------|----------------------------|------------|
| Intangible  assets:                    |       |       |       |                    |       |                       |       |
| UNIX (reseller channel and trade name) |       |       |       | $                       | 2,962      |                       | $          | 4,740 |   |
| SCOsource (UNIX technology)            |       |       |       | 421                     |       | 673                        |       |
| Total intangible assets                |       |       |       | $                       | 3,383      |                       | $          | 5,413 |   |

 

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**ITEM2.****                  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*This Management’s Discussion and Analysis ofFinancial Condition and Results of Operations and other parts of this quarterlyreport on Form 10-Q contain forward-looking statements that involve risksand uncertainties. Forward-looking statements can also be identified by wordssuch as “intends,” “anticipates,” “expects,” “believes,” “plans,” “predicts,”and similar terms. Forward-looking statements are not guarantees of futureperformance and our actual results may differ significantly from the resultsdiscussed in the forward-looking statements. Factors that might cause suchdifferences include, but are not limited to, those set forth below under “Forward-LookingStatements” and “Risk Factors” and elsewhere in this Form 10-Q. Thefollowing discussion should be read in conjunction with our consolidatedfinancial statements and notes thereto included in this Form 10-Q and ourannual report on Form 10-K for the year ended October 31, 2004 filedwith the Securities and Exchange Commission, including the audited financialstatements and management’s discussion and analysis contained therein. Allinformation presented herein is based on the three and nine months ended July 31,2005. We assume no obligation to revise or update any forward-lookingstatements for any reason, except as required by law.*

 

**Overview**

 

*Historical Background.*Weoriginally incorporated as Caldera Systems, Inc., a Utah corporation (“CalderaSystems”), and reincorporated as a Delaware corporation on March 6, 2000. InMarch 2000, we completed an initial public offering of our common stock. On May 7, 2001, we formed a new holdingcompany in Delaware under the name of Caldera International, Inc. toacquire substantially all of the assets and operations of the server andprofessional services groups of The Santa Cruz Operation (now Tarantella, Inc.).In connection with this acquisition, Caldera Systems became a wholly ownedsubsidiary of Caldera International, Inc. Former holders of sharesand options to purchase shares of Caldera Systems received an equal number ofshares and options to purchase shares in Caldera International, Inc. OnMay 16, 2003, our stockholders approved our corporate name change to TheSCO Group, Inc. As used herein, “we,” “us” and the “Company” refer to TheSCO Group, Inc.

 

*Recent Developments.*****As described elsewhere in this Form 10-Q,we issued certain shares andgranted certain options under our 1998 Stock Option Plan, our 1999 OmnibusStock Incentive Plan, the 2000 Employee Stock Purchase Plan (the “ESPP”), our2002 Omnibus Stock Incentive Plan, and our 2004 Omnibus Stock Incentive Plan(collectively, the “EquityCompensation Plans”) without complying with registration orqualification requirements under federal securities laws or the securities lawsof California, Utah and possibly other states. As a result, certain planparticipants have a right to rescind their purchases of shares under the EquityCompensation Plans or recover damages if they no longer own the shares or holdunexercised options, subject to applicable statutes of limitations. We arecurrently in the process of preparing a rescission offer for participants inthe ESPP entitled to rescission rights, subject to obtaining requiredregulatory approvals. On July 28, 2005, we filed a registration statementon Form S-1 with the SEC to register our repurchase of approximately313,000 shares issued under the ESPP from current or former participants in theESPP. As of the date of the filing of this quarterly report on Form 10-Q,the SEC has not declared the Form S-1 registration statement effective. Ifour potential rescission offer is made and accepted by all plan participantsholding certain ESPP shares, or participants in the Equity Compensation Plansotherwise make rescission claims against us, we could be required to makeaggregate payments to these plan participants of up to $1,104,000. This amountis based on shares issued pursuant to the ESPP and shares issued upon theexercise of stock options that have been retained by plan participants as of July 31,2005 and excludes interest and other charges we may be required to pay sinceany loss is considered reasonably possible but not estimable. We may faceadditional rescission liability to plan participants holding unexercised

 

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stock options in California, Georgia and possiblyother states, and regulatory authorities also may require us to pay fines orimpose other sanctions on us.

 

**Business Focus**

 

We generate revenue fromsales of products and services from our UNIX business and from sales ofSCOsource intellectual property (“IP”) agreements and vendor licenses from ourSCOsource business.

 

*UNIX Business.*Our UNIX business serves the needs ofsmall-to-medium sized businesses, including replicated site franchisees ofFortune 1000 companies, by providing reliable, cost effective UNIX softwaretechnology for distributed, embedded and network-based systems. Our largest source of UNIX business revenue isderived from existing customers through our worldwide, indirect, leveragedchannel of partners which includes distributors and independent solutionproviders. We have a presence in a number of countries that provide support andservices to customers and resellers. The other principal channel for sellingand marketing 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 (“ASMs”) in the United States and through our reseller channelin countries outside the United States. In addition, we also sell our operatingsystem products to original equipment manufacturers (“OEMs”). Our sales of UNIXproducts and services during the last several quarters have been primarily topre-existing UNIX customers and not newly acquired customers. Our UNIX businessrevenue depends significantly on our ability to market and sell our products toexisting customers and to generate upgrades from existing customers.

 

The following table shows theoperating results of the UNIX business for the three and nine months ended July 31,2005 and 2004 (in thousands):

 
| ** **                    | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                    | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                          |       |                                 |       |                                |       |   |   |   |   |
| Revenue                       |       | $                                    | 9,321      |                                | $          | 10,527 |   | $ | 27,344 |   | $ | 32,025 |   |
| Cost of revenue               |       | 1,395                                |       | 1,619                               |       | 4,097 |   | 5,637 |   |
| Gross margin                  |       | 7,926                                |       | 8,908                               |       | 23,247 |   | 26,388 |   |
| Sales and  marketing          |       | 2,935                                |       | 3,740                               |       | 8,681 |   | 12,868 |   |
| Research and  development     |       | 1,843                                |       | 2,361                               |       | 5,838 |   | 7,838 |   |
| General and  administrative   |       | 1,556                                |       | 1,761                               |       | 5,094 |   | 5,643 |   |
| Other                         |       | 593                                  |       | 863                                 |       | 1,801 |   | 5,662 |   |
| Total operating expenses      |       | 6,927                                |       | 8,725                               |       | 21,414 |   | 32,011 |   |
| Income (loss) from operations |       | $                                    | 999        |                                | $          | 183 |   | $ | 1,833 |   | $ | (5,623 | ) |
|                               |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |

 

Revenue from our UNIXbusiness decreased by $1,206,000, or 11 percent, for the three months ended July 31,2005 compared to the three months ended July 31, 2004 and decreased by$4,681,000, or 15 percent, for the nine months ended July 31, 2005compared to the nine months ended July 31, 2004. The revenue from thisbusiness has been declining over the last several quarters primarily as aresult of increased competition from alternative operating systems,particularly Linux. If revenue from our UNIX business declines and ourUNIX business is unable to generate positive cash flow, our results ofoperations will be adversely impacted.

 

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In an effort to attainprofitability in our UNIX business, we have decreased our operating costs andstreamlined our operations. Operating costs for our UNIX business decreasedfrom $8,725,000 for the three months ended July 31, 2004 to $6,927,000 forthe three months ended July 31, 2005 and decreased from $32,011,000 forthe nine months ended July 31, 2004 to $21,414,000 for the nine monthsended July 31, 2005. These cost reductions have primarily beenattributable to reduced headcount, continued operational efficiencies generatedin our UNIX business, the elimination of certain write-offs and severance andexit costs, as well as from the consolidation of certain facilities.

 

In our UNIX business, we havereduced the number of full-time equivalent employees from 224 as of July 31,2004, to 163 as of July 31, 2005. We have taken these headcount reductionsand reduced other discretionary spending while still maintaining a worldwidepresence. Based on our cost-cutting actions, we anticipate that our UNIXbusiness will continue to generate income from operations and positive cashflow for the three months ending October 31, 2005.

 

The decline in our UNIXbusiness revenue may be accelerated if industry partners withdraw their supportas a result of our SCOsource initiatives. The decline in our UNIX business andour SCOsource initiatives may cause industry partners, developers and hardwareand software vendors to choose not to support or certify to our UNIX operatingsystem products. This would lead to an accelerated decline in revenue from ourUNIX business.

 

An important initiative forour UNIX business for the year ending October 31, 2005 was the release of thenext major upgrade to our OpenServer product, OpenServer 6, which was completed in June 2005. OpenServer 6 providesincreased system reliability, backward compatibility with existing applicationsand software, increased application and hardware support, integration withwidely used internet applications and increased system performance. Weanticipate that these enhancements will not have a direct impact on ourshort-term OpenServer revenue because of the long adoption cycle for newoperating system purchases and our long operating system product sales cycle,but we believe that they will help prolong our OpenServer revenue stream forfuture quarters.

 

*SCOsource Business.*During the year ended October 31, 2003,we became aware that our UNIX code and derivative works had beeninappropriately included in the Linux operating system. We believe theinclusion of our UNIX code and derivative works in Linux has been a majorcontributor to the decline in our UNIX business because users of Linuxgenerally do not pay for the operating system but pay only minimal fees, ifany, for service and maintenance. The Linux operating system competes directlywith our UNIX products and has taken significant market share from theseproducts.

 

In an effort to protect ourUNIX intellectual property, we initiated our SCOsource business. Theinitiatives of this business include seeking to enter into license agreementswith UNIX vendors and offering SCOsource IP agreements to Linux and other endusers allowing them to continue to use our UNIX source code and derivativeworks found in Linux. We believe that our SCOsource revenue opportunities havebeen adversely impacted by our outstanding dispute with Novell over our UNIXcopyright ownership, which may have caused many potential customers to delay orforego licensing until an outcome in this legal matter has been reached.

 

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The following table shows theoperating results of the SCOsource business for the three and nine months endedJuly 31, 2005 and 2004 (in thousands):

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                        |       |                                 |       |                                |       |   |   |   |   |
| Revenue                     |       | $                                    | 32         |                                | $          | 678 |   | $ | 132 |   | $ | 709 |   |
| Cost of revenue             |       | 3,085                                |       | 7,396                               |       | 9,467 |   | 15,486 |   |
| Gross deficit               |       | (3,053                               | )          | (6,718                              | )          | (9,335 | ) | (14,777 | ) |
| Sales and  marketing        |       | —                               |       | 493                                 |       | 154 |   | 1,084 |   |
| Research and development    |       | 97                                   |       | 231                                 |       | 299 |   | 329 |   |
| General and  administrative |       | 91                                   |       | 128                                 |       | 352 |   | 150 |   |
| Total operating expenses    |       | 188                                  |       | 852                                 |       | 805 |   | 1,563 |   |
| Loss from operations        |       | $                                    | (3,241     | )                                   | $          | (7,570 | ) | $ | (10,140 | ) | $ | (16,340 | ) |

 

Revenue from our SCOsourcebusiness decreased from $678,000 for the three months ended July 31, 2004to $32,000 for the three months ended July 31, 2005 and decreased from$709,000 for the nine months ended July 31, 2004 to $132,000 for the ninemonths ended July 31, 2005. Revenue in the above-mentioned periods wasprimarily attributable to sales of our SCOsource IP agreements. Becauseof the uncertainties related to our SCOsource business, we are unable toestimate the amount and timing of future SCOsource revenue.

 

This uncertainty represents a significant risk andchallenge for us, both in the short and long term. If we do receive revenuefrom this source, it may be sporadic and fluctuate from quarter to quarter. OurSCOsource initiatives are unlikely to produce a stable or predictable revenuestream for the foreseeable future. We are unlikely to generate significantrevenue from our SCOsource business unless and until we prevail in ourlitigation with IBM, Red Hat, Novell, Daimler Chrysler and AutoZone (the “SCOLitigation”). Additionally, the success of these initiatives may depend on thestrength of our intellectual property rights and contractual claims regardingUNIX, including the strength of our claim that unauthorized UNIX source codeand derivative works are prevalent in Linux.

 

Cost of revenue, whichprimarily includes legal and professional fees incurred in connection with theSCO Litigation, decreased from $7,396,000 in the three months ended July 31,2004 to $3,085,000 in the three months ended July 31, 2005 and decreasedfrom $15,486,000 in the nine months ended July 31, 2004 to $9,467,000 inthe nine months ended July 31, 2005. The decrease in cost of revenue isprimarily attributable to our modified fee agreement with the law firms (the “LawFirms”) representing us in the SCO Litigation that has significantly reducedour ongoing and future operating expenses. Operating expenses for sales andmarketing, research and development and general and administrative decreased inthe three and nine months ended July 31, 2005 from the three and ninemonths ended July 31, 2004, which was primarily attributable to decreasedpersonnel and related costs.

 

Our future success with ourSCOsource initiatives and future revenue from SCOsource initiatives will dependon our ability to protect our UNIX intellectual property.

 

26

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**CriticalAccounting Policies**

 

Our critical accountingpolicies and estimates include the following:

 

•                              Revenue recognition;

 

•                              Deferred income taxes and related valuation allowances;

 

•                              Severance and exit costs;

 

•                              Impairment of long-lived assets; and

 

•                              Allowance for doubtful accounts.

 

*Revenue Recognition*.We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, asmodified by SOP 98-9. Revenue recognition in accordance with thesepronouncements is complex due to the nature and variability of our salestransactions. We recognize products revenue upon shipment if a signed contractexists, 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 have revenue transactions that includemultiple elements (such as products, maintenance, technical support servicesand other services). For software agreements that have multiple elements, weallocate revenue to each component of the contract based on vendor specificobjective evidence (“VSOE”). VSOE is established when such elements are soldseparately. We recognize revenue when the criteria for product revenuerecognition set forth above have been met. 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, thefair value of the undelivered elements is deferred and the remaining portion ofthe license fee is recognized as revenue in the period when persuasive evidenceof an arrangement is obtained assuming all other revenue recognition criteria aremet. We recognize revenue allocated to undelivered products when the criteriafor revenue recognition set forth above have been met.

 

Estimates used in revenue recognition include thedetermination of credit-worthiness of our customers, verification of sales-outreporting to end users through our two-tier distribution channel and theestimation of potential returns. In addition to these estimates, we alsoprovide reserves against revenue based on historical trends and experience. Tothe extent our estimates are incorrect, or we are not able to maintain VSOE,our recognized revenue could be adversely impacted and would harm our resultsof operations. Additionally, if our business conditions change or our revenuecontracts begin to contain more multiple elements, our revenue recognition infuture periods may be impacted because a larger component of revenue may bedeferred.

 

*Deferred Income Taxes and RelatedValuation Allowance*. The amount, and ultimate realization, ofour deferred income tax assets depends, in part, upon the tax laws in effect,our future earnings and other future events, the effects of which cannot bedetermined. We have provided a valuation allowance of $66,655,000 against ourentire net deferred tax asset as of October 31, 2004. The valuationallowance was recorded because of our history of net operating losses and theuncertainties regarding our future operating profitability and taxable income.

 

*Severance and Exit Costs.* Sincethe year ended October 31, 2001, we have undertaken significantrestructuring activities to reduce our ongoing cost of operations. Allrestructurings that occurred prior to the year ended October 31, 2003 wereaccounted for in accordance with Emerging Issues Task Force (“EITF”) No. 94-3“Liability Recognition for Certain Employee Termination Benefits and OtherCosts to Exit an Activity.” For restructuring activities initiated beginningwith

 

27

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the year ended October 31, 2003, we haveaccounted for the one-time termination benefits, contract termination costs andother associated costs in accordance with SFAS No. 146 “Accounting forCosts Associated with Exit or Disposal Activities.” Other severance benefitshave been accounted for in accordance with SFAS No. 112 “Employers’Accounting for Postemployment Benefits.” and SFAS No. 88 “Employers’Accounting for Settlements and Curtailments of Defined Benefit Plans and forTermination Benefits.”

 

Each restructuring has required us to make estimatesand assumptions related to losses on vacated facilities, provisions fortermination benefits, outplacement costs and other costs. Pursuant to therelevant accounting literature, we may record an accrual for amounts associatedwith a restructuring that are not paid in the current period. We regularlyevaluate the adequacy of the accruals based on changes in estimates. We mayincur future charges for new restructuring activities. As of July 31,2005, we did not have any amounts accrued for severance and exit costs.

 

*Impairment of Long-lived Assets*.We review our long-lived assets for impairment when events or changes incircumstances indicate that the book value of an asset may not be recoverable. Weevaluate, at each balance sheet date, whether events and circumstances haveoccurred which indicate possible impairment. The carrying value of a long-livedasset is considered impaired when the anticipated cumulative undiscounted cashflows of the related asset or group of assets is less than the carrying value. Inthat event, a loss is recognized based on the amount by which the carryingvalue exceeds the estimated fair value of the long-lived asset.

 

If the operating trends for our UNIX or SCOsourcebusinesses decline, we may be required to record an impairment charge in afuture period related to the carrying value of our long-lived assets.

 

*Allowance for Doubtful Accounts*. We offer credit terms on the sale of ourproducts to a majority of our customers and require no collateral from thesecustomers. We perform ongoing credit evaluations of our customers’ financialcondition and maintain an allowance for doubtful accounts based upon ourhistorical collection experience and expected collectibility of all accountsreceivable and have applied these policies consistently throughout the lastthree fiscal years. Our allowance for doubtful accounts, which is determinedbased on our historical experience and a specific review of customer balances,was $109,000 as of July 31, 2005. Our past experience has resulted inminimal differences from the actual amounts provided for bad debts and ourrecorded estimates. However, our actual bad debts in future periods may differfrom our current estimates and the differences may be material, whichmay have an adverse impact on our future accounts receivable and cash position.

 

28

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**Results of Operations**

 

The following tablepresents our results of operations for the three and nine months ended July 31,2005 and 2004 (in thousands):

 
| ** **                                                                | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Statement of Operations Data:**                                         |       |                                 |       |                                |       |   |   |   |   |
|                                                                      |       |                                 |       |                                |       |   |   |   |   |
| Revenue:                                                                  |       |                                 |       |                                |       |   |   |   |   |
| Products                                                                  |       | $                                    | 7,953      |                                | $          | 8,929 |   | $ | 23,095 |   | $ | 27,056 |   |
| SCOsource licensing                                                       |       | 32                                   |       | 678                                 |       | 132 |   | 709 |   |
| Services                                                                  |       | 1,368                                |       | 1,598                               |       | 4,249 |   | 4,969 |   |
| Total revenue                                                             |       | 9,353                                |       | 11,205                              |       | 27,476 |   | 32,734 |   |
| Cost of revenue:                                                          |       |                                 |       |                                |       |   |   |   |   |
| Products                                                                  |       | 695                                  |       | 741                                 |       | 1,902 |   | 2,364 |   |
| SCOsource licensing                                                       |       | 3,085                                |       | 7,396                               |       | 9,467 |   | 15,486 |   |
| Services                                                                  |       | 700                                  |       | 878                                 |       | 2,195 |   | 3,273 |   |
| Total cost of revenue                                                     |       | 4,480                                |       | 9,015                               |       | 13,564 |   | 21,123 |   |
| Gross margin                                                              |       | 4,873                                |       | 2,190                               |       | 13,912 |   | 11,611 |   |
| Operating expenses:                                                       |       |                                 |       |                                |       |   |   |   |   |
| Sales and marketing                                                       |       | 2,935                                |       | 4,233                               |       | 8,835 |   | 13,952 |   |
| Research and development                                                  |       | 1,940                                |       | 2,592                               |       | 6,137 |   | 8,167 |   |
| General and administrative                                                |       | 1,647                                |       | 1,889                               |       | 5,446 |   | 5,793 |   |
| Loss on disposition of long-lived assets                                  |       | —                               |       | —                              |       | — |   | 2,139 |   |
| Severance and exit costs                                                  |       | —                               |       | —                              |       | — |   | 682 |   |
| Amortization of intangibles                                               |       | 593                                  |       | 593                                 |       | 1,779 |   | 1,973 |   |
| Stock-based compensation                                                  |       | —                               |       | 270                                 |       | 22 |   | 868 |   |
| Total operating expenses                                                  |       | 7,115                                |       | 9,577                               |       | 22,219 |   | 33,574 |   |
| Loss from operations                                                      |       | (2,242                               | )          | (7,387                              | )          | (8,307 | ) | (21,963 | ) |
| Equity in income (losses) of affiliate                                    |       | (19                                  | )          | 41                                  |       | 51 |   | 115 |   |
| Other income (expense), net                                               |       | (27                                  | )          | 99                                  |       | 1,282 |   | 6,284 |   |
| Provision for income taxes                                                |       | (84                                  | )          | (176                                | )          | (321 | ) | (1,270 | ) |
| Net loss                                                                  |       | (2,372                               | )          | (7,423                              | )          | (7,295 | ) | (16,834 | ) |
| Contributions from (dividends on) redeemable  convertible preferred stock |       | —                               |       | 14,924                              |       | — |   | 7,123 |   |
| Net income attributable (loss applicable) to common  stockholders         |       | $                                    | (2,372     | )                                   | $          | 7,501 |   | $ | (7,295 | ) | $ | (9,711 | ) |

 

**THREE AND NINE MONTHS ENDED JULY 31, 2005 AND 2004**

 

*Revenue*

 
| ** ** | ** ** | **Three Months Ended July 31,** | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|       |       |                                 |       |   |   |   |   |
| Revenue    |       | $                                    | 9,353,000  |   | (17 | )% | $ | 11,205,000 |   |
|            |            |                                      |            |  |  |  |  |  |  |

 
| ** ** | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------|------------|-------------------------------------|------------|
| ** ** | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|       |       |                                |       |   |   |   |   |
| Revenue    |       | $                                   | 27,476,000 |   | (16 | )% | $ | 32,734,000 |   |
|            |            |                                     |            |  |  |  |  |  |  |

 

Revenue for the three months ended July 31, 2005decreased by $1,852,000, or 17 percent, from the three months ended July 31,2004, and revenue for the nine months ended July 31, 2005 decreased by$5,258,000, or 16 percent, from the nine months ended July 31, 2004. These

 

29

----

 

decreaseswere primarily attributable to a continued decline in the revenue generatedfrom our UNIX business and a decline in revenue from our SCOsource business.

 

Revenue generated from our UNIX business andSCOsource business is as follows:

 
| ** **               | ** ** | **Three Months Ended July 31,** | ** ** |
|--------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                     |       |                                 |       |   |   |   |   |
| UNIX revenue             |       | $                                    | 9,321,000  |   | (11 | )% | $ | 10,527,000 |   |
| Percent of total revenue |       | 100                                  | %          |   |   | 94 | % |
| SCOsource revenue        |       | 32,000                               |       | (95 | )% | 678,000 |   |
| Percent of total revenue |       | 0                                    | %          |   |   | 6 | % |
|                          |            |                                      |            |  |  |  |  |  |  |

 
| ** **                | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                      |       |                                |       |   |   |   |   |
| UNIX revenue              |       | $                                   | 27,344,000 |   | (15 | )% | $ | 32,025,000 |   |
| Percent of total  revenue |       | 100                                 | %          |   |   | 98 | % |
| SCOsource  revenue        |       | 132,000                             |       | (81 | )% | 709,000 |   |
| Percent of total  revenue |       | 0                                   | %          |   |   | 2 | % |
|                           |            |                                     |            |  |  |  |  |  |  |

 

Thedecrease in revenue in the UNIX business of $1,206,000 for the three monthsended July 31, 2005 compared to the three months ended July 31, 2004and the decrease in UNIX revenue of $4,681,000 for the nine months ended July 31,2005 compared to the nine months ended July 31, 2004 was primarilyattributable to continued competition from other operating systems,particularly Linux. We anticipate that for the three months ending October 31,2005 and for future periods our UNIX business and the related revenue from theUNIX business will face significant competition from Linux and other operatingsystems. The decrease in SCOsource revenue for the three and nine months ended July 31,2005 compared to the three and nine months ended July 31, 2004 wasprimarily attributable to decreased sales of SCO IP agreements.

 

Salesof our UNIX products and services during the three and nine months ended July 31,2005 were primarily to pre-existing customers. Our UNIX business revenuedepends significantly on our ability to market our products to existing customersand to generate upgrades from existing customers. 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. This may occur as a result of thedecline of our UNIX business and our SCOsource initiatives.

 

*Products Revenue*

 
| ** **                | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                      |       |                                 |       |   |   |   |   |
| Products revenue          |       | $                                    | 7,953,000  |   | (11 | )% | $ | 8,929,000 |   |
| Percent of total  revenue |       | 85                                   | %          |   |   | 80 | % |
|                           |            |                                      |            |  |  |  |  |  |  |

 
| ** **                | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                      |       |                                |       |   |   |   |   |
| Products revenue          |       | $                                   | 23,095,000 |   | (15 | )% | $ | 27,056,000 |   |
| Percent of total  revenue |       | 84                                  | %          |   |   | 83 | % |
|                           |            |                                     |            |  |  |  |  |  |  |

 

30

----

 

Our products revenue consists of software licensesfor UNIX products such as OpenServer and UnixWare, as well as sales ofUNIX-related products. Products revenue also includes revenue derived fromOEMs, distribution partners and large accounts. We rely heavily on our two-tierdistribution channel and any disruption in our distribution channel could havean adverse impact on future revenue.

 

The decrease in products revenue of $976,000 from thethree months ended July 31, 2005 compared to the three months ended July 31,2004 and the decrease in products revenue of $3,961,000 from the nine monthsended July 31, 2005 compared to the nine months ended July 31, 2004was primarily attributable to decreased sales of OpenServer and UnixWareproducts primarily resulting from increased competition in the operating systemmarket, particularly Linux. We believe that this competition from Linux willcontinue for the three months ending October 31, 2005 and future periods.

 

Ourproducts revenue was derived primarily from sales of our OpenServer andUnixWare products. Other products revenue consists mainly of productmaintenance and other UNIX-related products. Revenue for these products was asfollows:

 
| ** **                   | ** ** | **Three Months Ended July 31,** | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                         |       |                                 |       |   |   |   |   |
| OpenServer  revenue          |       | $                                    | 4,309,000  |   | (4 | )% | $ | 4,496,000 |   |
| Percent of  products revenue |       | 54                                   | %          |   |   | 50 | % |
| UnixWare revenue             |       | 2,085,000                            |       | (30 | )% | 2,984,000 |   |
| Percent of  products revenue |       | 26                                   | %          |   |   | 34 | % |
| Other products  revenue      |       | 1,559,000                            |       | 8 | % | 1,449,000 |   |
| Percent of  products revenue |       | 20                                   | %          |   |   | 16 | % |
|                              |            |                                      |            |  |  |  |  |  |  |

 

 
| ** **                   | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                         |       |                                |       |   |   |   |   |
| OpenServer  revenue          |       | $                                   | 12,987,000 |   | (9 | )% | $ | 14,278,000 |   |
| Percent of  products revenue |       | 56                                  | %          |   |   | 53 | % |
| UnixWare revenue             |       | 6,606,000                           |       | (20 | )% | 8,240,000 |   |
| Percent of  products revenue |       | 29                                  | %          |   |   | 30 | % |
| Other products  revenue      |       | 3,502,000                           |       | (23 | )% | 4,538,000 |   |
| Percent of  products revenue |       | 15                                  | %          |   |   | 17 | % |
|                              |            |                                     |            |  |  |  |  |  |  |

 

OpenServerrevenue for the three and nine months ended July 31, 2005 decreasedcompared to the three months ended July 31, 2004 and this decrease wasprimarily attributable to continued competition. UnixWare revenue for the threeand nine months ended July 31, 2005 was lower than the three and ninemonths ended July 31, 2004 primarily as a result of decreased project business.The increase in other products revenue from the three months ended July 31,2005 compared to the three months ended July 31, 2004 was primarilyattributable to the recognition of certain previously deferred amounts forupgrade revenue that were recognized upon the release and shipment ofOpenServer 6.  The decrease in otherproducts revenue for the nine months ended July 31, 2005 compared to the ninemonths ended July 31, 2004 was primarily attributable to decreasedmaintenance sales.

 

31

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*SCOsource Licensing Revenue*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                                 |       |   |   |   |   |
| SCOsource licensing revenue |       | $                                    | 32,000     |   | (95 | )% | $ | 678,000 |   |
| Percent of total  revenue   |       | 0                                    | %          |   |   | 6 | % |
|                             |            |                                      |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                                |       |   |   |   |   |
| SCOsource licensing revenue |       | $                                   | 132,000    |   | (81 | )% | $ | 709,000 |   |
| Percent of total  revenue   |       | 0                                   | %          |   |   | 2 | % |
|                             |            |                                     |            |  |  |  |  |  |  |

 

We initiated our SCOsource business for the purposeof protecting our intellectual property rights in our UNIX source code andderivative works. SCOsource licensing revenue was $32,000 in the three monthsended July 31, 2005 compared to revenue of $678,000 generated in the threemonths ended July 31, 2004. SCOsource licensing revenue was $132,000 inthe nine months ended July 31, 2005 compared to revenue of $709,000 in thenine months ended July 31, 2004. Our SCOsource licensing revenue wasprimarily generated from the sales of SCO IP agreements. During the three andnine months ended July 31, 2004 we entered into one large transaction witha customer for a total of $500,000.

 

We are unable to predict the amount and timing offuture SCOsource licensing revenue, and when generated, the revenue will besporadic.

 

*Services Revenue*

 
| ** **                | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                      |       |                                 |       |   |   |   |   |
| Services revenue          |       | $                                    | 1,368,000  |   | (14 | )% | $ | 1,598,000 |   |
| Percent of total  revenue |       | 15                                   | %          |   |   | 14 | % |
|                           |            |                                      |            |  |  |  |  |  |  |

 
| ** **                | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                      |       |                                |       |   |   |   |   |
| Services revenue          |       | $                                   | 4,249,000  |   | (14 | )% | $ | 4,969,000 |   |
| Percent of total  revenue |       | 16                                  | %          |   |   | 15 | % |
|                           |            |                                     |            |  |  |  |  |  |  |

 

Services revenue consists primarily of technicalsupport fees, engineering services fees, professional services and consulting fees,and education fees. These fees are typically charged and invoiced separatelyfrom UNIX products sales. The decrease in services revenue of $230,000, or 14percent, from the three months ended July 31, 2004 as compared to thethree months ended July 31, 2005 and the decrease in services revenue of$720,000, or 14 percent, from the nine months ended July 31, 2004 ascompared to the nine months ended July 31, 2005, was in part due to thedecrease in products revenue, fewer customers renewing services agreements anda decrease in professional services revenue.

 

The majority of our support and professional servicesrevenue continues to be derived from services for UNIX-based operating systemproducts. Our future level of services revenue depends in part on our abilityto generate UNIX products revenue from new customers as well as to renew annualsupport and services agreements with existing UNIX customers.

 

32

----

 

*Cost of Products Revenue*

 
| ** **                      | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                            |       |                                 |       |   |   |   |   |
| Cost of products  revenue       |       | $                                    | 695,000    |   | (6 | )% | $ | 741,000 |   |
| Percentage of  products revenue |       | 9                                    | %          |   |   | 8 | % |
|                                 |            |                                      |            |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------|------------|-------------------------------------|------------|
| ** **                     | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                           |       |                                |       |   |   |   |   |
| Cost of products revenue       |       | $                                   | 1,902,000  |   | (20 | )% | $ | 2,364,000 |   |
| Percentage of products revenue |       | 8                                   | %          |   |   | 9 | % |
|                                |            |                                     |            |  |  |  |  |  |  |

 

Cost of products revenue consists of manufacturingcosts, royalties to third-party vendors, technology costs and overhead costs. Costof products revenue decreased by $46,000, or 6 percent, in the three monthsended July 31, 2005 as compared to the three months ended July 31,2004 and decreased by $462,000, or 20 percent, in the nine months ended July 31,2005 compared to the nine months ended July 31, 2004. This decrease in thedollar amount of cost of products revenue was primarily attributable to lowerproducts revenue, lower manufacturing costs, and lower amortized technologycosts.

 

Forthe three months ending October 31, 2005, we expect the dollar amount ofour cost of products revenue to be generally consistent with cost of productsrevenue incurred in the three months ended July 31, 2005 and that cost ofproducts revenue as a percentage of products revenue for the three monthsending October 31, 2005 will be generally consistent to that incurred inthe three months ended July 31, 2005.

 

*Cost of SCOsource Licensing Revenue*

 
| ** **                          | ** ** | **Three Months Ended July 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|
| ** **                          | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                                |       |                                 |       |   |   |   |   |
| Cost of SCOsource licensing revenue |       | $                                    | 3,085,000  |   | (58 | )% | $ | 7,396,000 |   |
|                                     |            |                                      |            |  |  |  |  |  |  |

 
| ** **                          | ** ** | **Nine Months Ended July 31,** | ** ** |
|-------------------------------------|------------|-------------------------------------|------------|
| ** **                          | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                                |       |                                |       |   |   |   |   |
| Cost of SCOsource licensing revenue |       | $                                   | 9,467,000  |   | (39 | )% | $ | 15,486,000 |   |
|                                     |            |                                     |            |  |  |  |  |  |  |

 

Cost of SCOsource licensing revenue includes legaland professional fees incurred in connection with our SCO Litigation, thesalaries and related personnel costs of SCOsource employees, and an allocationof corporate costs.

 

Cost of SCOsource licensing revenue decreased by$4,311,000 during the three months ended July 31, 2005 as compared to thethree months ended July 31, 2004 and decreased by $6,019,000 during thenine months ended July 31, 2005 as compared to the nine months ended July 31,2004. The decrease in costs in the three months ended July 31, 2005compared to the three months ended July 31, 2004 was primarilyattributable to decreased legal costs incurred in connection with our SCOLitigation as a result of our Engagement Agreement.

 

According to the terms of our Engagement Agreementwith the Law Firms described in more detail below in this Item 2 of Part Iof this Form 10-Q, we anticipate that the dollar amount of our cost ofSCOsource licensing for the three months ending October 31, 2005 will begenerally consistent to or slightly higher than the costs incurred in the threemonths ended July 31, 2005.

 

33

----

 

However, future legalfees may include contingency payments made to the Law Firms as a result of asettlement, judgment, certain licensing fees or a sale of our Company, whichcould cause cost of SCOsource licensing revenue to be higher than anticipated.

 

*Cost of Services Revenue*

 
| ** **                      | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                            |       |                                 |       |   |   |   |   |
| Cost of services  revenue       |       | $                                    | 700,000    |   | (20 | )% | $ | 878,000 |   |
| Percentage of  services revenue |       | 51                                   | %          |   |   | 55 | % |
|                                 |            |                                      |            |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------|------------|-------------------------------------|------------|
| ** **                     | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                           |       |                                |       |   |   |   |   |
| Cost of services revenue       |       | $                                   | 2,195,000  |   | (33 | )% | $ | 3,273,000 |   |
| Percentage of services revenue |       | 52                                  | %          |   |   | 66 | % |
|                                |            |                                     |            |  |  |  |  |  |  |

 

Cost of services revenue includes the salaries andrelated personnel costs of employees delivering services revenue as well asthird-party service agreements. Cost of services revenue decreased by $178,000,or 20 percent, for the three months ended July 31, 2005 compared to thethree months ended July 31, 2004 and decreased by $1,078,000, or 33percent, for the nine months ended July 31, 2005 compared to the ninemonths ended July 31, 2004. This decrease was primarilyattributable to reduced employees and related costs.

 

Forthe three months ending October 31, 2005, we expect the dollar amount ofour cost of services revenue to be generally consistent to cost of servicesrevenue incurred in the three months ended July 31, 2005 and that cost ofservices revenue as a percentage of services revenue for the three monthsending October 31, 2005 will be generally consistent to that incurred inthe three months ended July 31, 2005.

 

*Sales and Marketing*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                                 |       |   |   |   |   |
| Sales and marketing expense |       | $                                    | 2,935,000  |   | (31 | )% | $ | 4,233,000 |   |
| Percentage of total revenue |       | 31                                   | %          |   |   | 38 | % |
|                             |            |                                      |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                                |       |   |   |   |   |
| Sales and marketing expense |       | $                                   | 8,835,000  |   | (37 | )% | $ | 13,952,000 |   |
| Percentage of total revenue |       | 32                                  | %          |   |   | 43 | % |
|                             |            |                                     |            |  |  |  |  |  |  |

 

Sales and marketing expense primarily consists of thesalaries, commissions and other personnel costs of employees involved in therevenue generation process, as well as advertising and corporate allocations. Thedecrease in sales and marketing expense of $1,298,000, or 31 percent, from thethree months ended July 31, 2004 compared to the three months ended July 31,2005 and the decrease of $5,117,000, or 37 percent, from the nine months ended July 31,2004 compared to the nine months ended July 31, 2005 was primarily attributableto reductions in sales and marketing employees, reduced travel expenses, lesscommissions and lower advertising costs. Our sales and marketing full-timeequivalent employees decreased from 73 as of July 31, 2004 to 53 as of July 31,2005.

 

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For the three months ending October 31, 2005, weanticipate that the dollar amount of sales and marketing expense will begenerally consistent to that incurred in the three months ended July 31,2005.

 

*Research and Development*

 
| ** **                       | ** ** | **Three Months Ended July 31,** | ** ** |
|----------------------------------|------------|--------------------------------------|------------|
| ** **                       | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                             |       |                                 |       |   |   |   |   |
| Research and development expense |       | $                                    | 1,940,000  |   | (25 | )% | $ | 2,592,000 |   |
| Percentage of total revenue      |       | 21                                   | %          |   |   | 23 | % |
|                                  |            |                                      |            |  |  |  |  |  |  |

 
| ** **                       | ** ** | **Nine Months Ended July 31,** | ** ** |
|----------------------------------|------------|-------------------------------------|------------|
| ** **                       | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                             |       |                                |       |   |   |   |   |
| Research and development expense |       | $                                   | 6,137,000  |   | (25 | )% | $ | 8,167,000 |   |
| Percentage of total revenue      |       | 22                                  | %          |   |   | 25 | % |
|                                  |            |                                     |            |  |  |  |  |  |  |

 

Research and development expense primarily consistsof the salaries and benefits of software engineers, consulting expenses andcorporate allocations. Research and development expense decreased by $652,000,or 25 percent, from the three months ended July 31, 2005 compared to thethree months ended July 31, 2004 and decreased by $2,030,000, or 25percent, from the nine months ended July 31, 2005 compared to the ninemonths ended July 31, 2004 and was primarily attributable to work forcereductions. Our research and development full-time equivalent employeesdecreased from 75 as of July 31, 2004 to 50 as of July 31, 2005.

 

For the three months ending October 31, 2005, weanticipate that the dollar amount of research and development expense will begenerally consistent to that incurred in the three months ended July 31,2005.

 

*General and Administrative*

 
| ** **                         | ** ** | **Three Months Ended July 31,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                               |       |                                 |       |   |   |   |   |
| General and administrative expense |       | $                                    | 1,647,000  |   | (13 | )% | $ | 1,889,000 |   |
| Percentage of total revenue        |       | 18                                   | %          |   |   | 17 | % |
|                                    |            |                                      |            |  |  |  |  |  |  |

 
| ** **                         | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                               |       |                                |       |   |   |   |   |
| General and administrative expense |       | $                                   | 5,446,000  |   | (6 | )% | $ | 5,793,000 |   |
| Percentage of total revenue        |       | 20                                  | %          |   |   | 18 | % |
|                                    |            |                                     |            |  |  |  |  |  |  |

 

General and administrative expense primarily consistsof the salaries and benefits of finance, human resources, and executivemanagement and expenses for professional services such as legal and accountingand corporate allocations. General and administrative expense decreased by$242,000, or 13 percent, during the three months ended July 31, 2005 ascompared to the three months ended July 31, 2004 and decreased by$347,000, or 6 percent, during the nine months ended July 31, 2005 ascompared to the nine months ended July 31, 2004. The decrease in generaland administrative expense during the three months ended July 31, 2005compared to the three months ended July 31, 2004 was primarilyattributable to decreased personnel and related costs offset by higher legaland accounting costs. The decrease in general and administrative expense forthe nine months ended July 31, 2005 compared to the nine months ended July 31,2004 was primarily attributable to lower personnel and related costs offset bythe increased costs for legal and accounting related to the restatement of ourquarterly financial statements. Our

 

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generaland administrative full-time equivalent employees decreased from 41 as of July 31,2004 to 29 as of July 31, 2005.

 

For the three months ending October 31, 2005, weanticipate that the dollar amount of general and administrative expenses willbe generally consistent to that incurred in the three months ended July 31,2005. However, due to the new compliance and reporting regulations under theSarbanes-Oxley Act and other new regulatory requirements, general andadministrative expenses may vary as we implement policies and procedures tocomply with these new requirements.

 

*Losson Impairment of Long-lived Assets*

 

Werecorded a loss on impairment of long-lived assets totaling $2,139,000 for thenine months ended July 31, 2004. The impairment related to goodwill andintangible assets acquired in connection with our acquisition of Vultus, Inc.(“Vultus”) in June 2003. We concluded that an impairment triggering eventoccurred during the three months ended April 30, 2004 as an impendingpartnership that would solidify the Vultus revenue and cash flow opportunitiesdid not materialize. Consequently, we concluded that no significant future cashflows related to our Vultus assets will be realized. We performed an impairmentanalysis of our recorded goodwill related to the Vultus reporting unit inaccordance with SFAS No. 142. Additionally, an impairment analysis of theintangible assets was performed in accordance with SFAS No. 144. As aresult of these analyses, we wrote-down the carrying value of our goodwillrelated to our Vultus acquisition from $1,166,000 to $0, and wrote-down theintangible assets related to our Vultus acquisition from $973,000 to $0.

 

We didnot incur any impairment charges in the three or nine months ended July 31,2005.

 

*Severance and Exit Costs*

 

Severance and exit costs were $0 for the threemonths ended July 31, 2005 and 2004, respectively, and were $0 and$682,000 for the nine months ended July 31, 2005 and 2004, respectively. Thecosts incurred in the nine months ended July 31, 2004 were primarilyattributable to headcount reductions.

 

The following table shows the activityrelated to the accrual for severance and exit costs for the nine months ended July 31,2005 (in thousands): 

 
| ** **                   | ** ** | **Balance at  November 1, 2004** | ** ** | **Additions** | ** ** | **Payments** | ** ** | **Balance at  July 31, 2005** | ** ** |
|------------------------------|------------|---------------------------------------|------------|---------------|------------|--------------|------------|------------------------------------|------------|
|                         |       |                                  |       |          |       |         |       |                               |       |
| Ongoing  severance and other |       | $                                     | 401        |          | $          | —       |       | $                                  | (401       | ) | $ | — |   |
|                              |            |                                       |            |               |            |              |            |                                    |            |  |  |  |  |

 

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*Amortization of Intangibles*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                                 |       |   |   |   |   |
| Amortization of intangibles |       | $                                    | 593,000    |   | 0 | % | $ | 593,000 |   |
| Percentage of total revenue |       | 6                                    | %          |   |   | 5 | % |
|                             |            |                                      |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                                |       |   |   |   |   |
| Amortization of intangibles |       | $                                   | 1,779,000  |   | (10 | )% | $ | 1,973,000 |   |
| Percentage of total revenue |       | 6                                   | %          |   |   | 6 | % |
|                             |            |                                     |            |  |  |  |  |  |  |

 

During the three monthsended July 31, 2005 and 2004, we recorded $593,000 for the amortization ofintangible assets with definite lives. For the nine months ended July 31,2005 and 2004, we recorded $1,779,000 and $1,973,000, respectively, inamortization. The decrease of $194,000, or 10 percent, from the nine monthsended July 31, 2005 compared to the nine months ended July 31, 2004was primarily attributable to reduced amortization expense recorded on certainassets acquired from Vultus in June 2003 that were written down to $0during the year ended October 31, 2004.

 

*Stock-basedCompensation*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2005**                             | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                                 |       |   |   |   |   |
| Stock-based compensation    |       | $                                    | —     |   | n/a |   | $ | 270,000 |   |
| Percentage of total revenue |       | 0                                    | %          |   |   | 2 | % |
|                             |            |                                      |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2005**                            | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                                |       |   |   |   |   |
| Stock-based compensation    |       | $                                   | 22,000     |   | (97 | )% | $ | 868,000 |   |
| Percentage of total revenue |       | 0                                   | %          |   |   | 3 | % |
|                             |            |                                     |            |  |  |  |  |  |  |

 

Stock-basedcompensation consisted of the following components for the three and ninemonths ended July 31, 2005 and 2004:

 
| ** **                                 | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                 | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                       |       |                                 |       |                                |       |   |   |   |   |
| Amortization of  stock-based compensation  |       | $                                    | —     |                                | $          | 51,000 |   | $ | 22,000 |   | $ | 274,000 |   |
| Options,  warrants and shares for services |       | —                               |       | 219,000                             |       | — |   | 502,000 |   |
| Modifications to  options                  |       | —                               |       | —                              |       | — |   | 92,000 |   |
| Total                                      |       | $                                    | —     |                                | $          | 270,000 |   | $ | 22,000 |   | $ | 868,000 |   |

 

As of July 31,2005, we had amortized all amounts related to deferred compensation.

 

*Equity inIncome (Losses) 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 equity method, we record our portion of theentities’ net income or net loss in our consolidated statements of

 

37

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operations and comprehensive loss. As of July 31,2005, the carrying value of our investments was related to our 30 percentownership in a Chinese company.

 

Duringthe three months ended July 31, 2005 and 2004, we recorded ($19,000) and$41,000, respectively, that related to equity in income (losses) of thisentity, and during the nine months ended July 31, 2005 and 2004, werecorded $51,000 and $115,000, respectively.

 

*OtherIncome (Expense), net*

 

Otherincome (expense), net, consisted of the following components for the three andnine months ended July 31, 2005 and 2004:

 
| ** **                          | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                          | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                |       |                                 |       |                                |       |   |   |   |   |
| Interest income                     |       | $                                    | 122,000    |                                | $          | 186,000 |   | $ | 257,000 |   | $ | 698,000 |   |
| Change in fair  value of derivative |       | —                               |       | —                              |       | — |   | 5,924,000 |   |
| Other income  (expense), net        |       | (149,000                             | )          | (87,000                             | )          | 1,025,000 |   | (338,000 | ) |
| Total                               |       | $                                    | (27,000    | )                                   | $          | 99,000 |   | $ | 1,282,000 |   | $ | 6,284,000 |   |

 

Interestincome decreased by $64,000 from the three months ended July 31, 2004 tothe three months ended July 31, 2005 and decreased by $441,000 from thenine months ended July 31, 2004 to the nine months ended July 31,2005 and was primarily attributable to a decrease in our cash andavailable-for-sale securities balances.

 

Theincome recorded on the change in fair value of derivative of $5,924,000 for thenine months ended July 31, 2004 related to the decrease in fair value ofthis instrument and marking it to market at each balance sheet date. Thederivative financial instrument was eliminated during the three months ended April 30,2004.

 

Theincrease in other income (expense), net, for the nine months ended July 31,2005 compared to the nine months ended July 31, 2004 was primarilyattributable to two items: 1) the collection of a note receivable from Vintela, Inc.(“Vintela”) as described in more detail in Note 9 to our financial statementsabove in Part I, Item 1 of this Form 10-Q, which note receivable wasoriginally received in April 2003, but because we received the notereceivable in exchange for the transfer of certain software to a related partyand there was substantial doubt concerning the ability of Vintela to repay thenote, no gain was recognized until the three months ended January 31, 2005when we received payment; and 2) the sale of shares we held in Troll Tech AS (“TrollTech”) as described in more detail in Note 4 to our financial statements abovein Part I, Item 1 of this Form 10-Q. The Troll Tech shares had beenwritten off in the year ended October 31, 2001, but because they were soldduring the three months ended July 31, 2005, we recorded income on theproceeds received.

 

*Provision for Income Taxes*

 

The provision for income taxes was $84,000 in thethree months ended July 31, 2005 and $176,000 in the three months ended July 31,2004. The provision for income taxes was $321,000 in the nine months ended July 31,2005 and $1,270,000 in the nine months ended July 31, 2004. Our provision for income taxes isprimarily related to earnings in foreign subsidiaries and withholding taxes onrevenue generated in certain locations. The decrease in the provision forincome taxes for the nine months ended July 31, 2005 as compared to thenine months ended July 31, 2004 is attributable to an accrual forwithholding taxes of approximately $710,000 that was made in the three monthsended April 30, 2004, which taxes were estimated to be paid in

 

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connection with the operations of the Indian branchof our United Kingdom subsidiary, SCO Group, Ltd.

 

*DividendsRelated to Convertible Preferred Stock*

 

The following table details the components ofdividends related to convertible preferred stock for the three and nine monthsended July 31, 2005 and 2004:

 
| ** **                                                   | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                         |       |                                 |       |                                |       |   |   |   |   |
| Accrual of  dividends                                        |       | $                                    | —     |                                | $          | (551,000 | ) | $ | — |   | $ | (2,047,000 | ) |
| Exchange of Series A  shares for Series A-1 shares |       | —                               |       | —                              |       | — |   | (6,305,000 | ) |
| Repurchase of Series A-1  shares from BayStar           |       | —                               |       | 15,475,000                          |       | — |   | 15,475,000 |   |
| Total                                                        |       | $                                    | —     |                                | $          | 14,924,000 |   | $ | — |   | $ | 7,123,000 |   |

 

**Liquidityand Capital Resources**

 

During the nine months ended July 31, 2005, weused cash of $19,460,000 in our operating activities. The majority of this cashwas used to pay accounts payable, accrued compensation to law firms and otherliabilities related to our SCO Litigation. As of July 31, 2005, we have atotal of $12,602,000 in cash and cash equivalents and available-for-salesecurities and an additional $4,004,000 in restricted cash, of which $3,579,000is designated to be used as payments for experts, consultants and otherexpenses in the SCO Litigation. As a result of the Engagement Agreement betweenus and the Law Firms, we anticipate using cash of approximately $3,250,000 tofund our SCO Litigation costs during the remainder of the year ending October 31,2005. We expect that our UNIX business will generate sufficient cash in theyear ending October 31, 2005 to cover its own costs as well as the internalcosts for our SCOsource initiatives and we believe we will have sufficient cashresources to fund our operations through October 31, 2005.

 

In the event that cash required to fund operations andstrategic initiatives exceeds our current cash resources and cash generatedfrom operating activities, we will be required to reduce costs and raiseadditional capital. We may not be able to reduce costs in a manner that doesnot impair our ability to maintain our UNIX business and pursue our SCOsourceinitiatives. We also may not be able to raise capital for any number of reasonsincluding those listed under the section “Risk Factors” below. Ifadditional equity financing is available, it may not be available to us onattractive terms and may be dilutive to our existing stockholders. In addition,if our stock price declines, we may not be able to access the public equitymarkets on acceptable terms, if at all. Our ability to effect acquisitions forstock would also be impaired.

 

Ourcash and equivalents balance decreased from $12,693,000 as of October 31,2004 to $6,526,000 as of July 31, 2005. During this same time period, ourinvestment in available-for-sale securities decreased from $18,756,000 to$6,076,000. During the nine months ended July 31, 2005, we expended asignificant amount of cash to pay accounts payable, accrued compensation to thelaw firms and other liabilities related to our intellectual propertylitigation. We intend to use the cash and cash equivalents andavailable-for-sale securities as of July 31, 2005 to maintain our UNIXbusiness and pursue our SCO Litigation.

 

Ournet cash used in operating activities during the nine months ended July 31,2005 was $19,460,000 and resulted from a net loss of $7,295,000 and changes inoperating assets and liabilities of $14,469,000, offset by non-cash items of$2,304,000. Our working capital decreased

 

39

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from $15,413,000 as of October 31,2004 to $11,063,000 as of July 31, 2005, primarily because of paymentsmade to the Law Firms for the SCO Litigation.

 

Our net cash used in operating activitiesduring the nine months ended July 31, 2004 was $10,703,000. Cash used inoperating activities resulted from a net loss of $16,834,000 and non-cashexpenses of $180,000, offset by changes in operating assets and liabilities of$6,311,000.

 

Ourinvesting activities have historically consisted of equipment purchases,investing in strategic partners and the purchase and sale of available-for-salesecurities. During the nine months ended July 31, 2005, cash provided byinvesting activities was $12,447,000, which was primarily a result of sales,net of purchases, of available-for-sale securities of $12,680,000, which amountwas offset by purchases of equipment of $233,000.

 

Duringthe nine months ended July 31, 2004, cash used in investing activities was$34,050,000, which was primarily a result of our purchase of available-for-salesecurities, net of sales, of $33,510,000, equipment purchases of $331,000, andthe purchase of the remaining minority interest in our Japanese subsidiary of$209,000.

 

Ourfinancing activities provided $955,000 of cash in the nine months ended July 31,2005. The primary sources of cash were from the exercise of options to acquirecommon stock of $235,000 and proceeds of $720,000 received from the sale ofcommon stock through our ESPP.

 

Ourfinancing activities used $14,224,000 during the nine months ended July 31,2004 and consisted primarily of $13,000,000 in cash to fund the repurchase of Series A-1shares from BayStar Capital II, L.P. cash used to purchase shares of our commonstock on the open market of $2,414,000 and cash used to exchange Series A-1for Series A shares of $211,000. These uses of cash were offset fromproceeds received from the exercise of stock options of $591,000 and proceedsfrom the purchase of shares of common stock by our employees through ouremployee stock purchase program of $810,000.

 

Ournet accounts receivable balance decreased from $6,638,000 as of October 31,2004 to $4,947,000 as of July 31, 2005, primarily as a result of lowerinvoicing and revenue in the three months ended July 31, 2005 and verystrong collections for the three months ended July 31, 2005. The majorityof our accounts receivable are current and our allowance for doubtful accountswas $109,000 as of July 31, 2005, which represented approximately 2percent of our gross accounts receivable balance. This percentage of grossaccounts receivable is consistent with our experience in prior periods, and weexpect this trend to continue. Our write-offs of uncollectible accounts duringthe nine months ended July 31, 2005 were not significant.

 

On October 31, 2004, weentered into the Engagement Agreement with the Law Firms. 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 thecurrent litigation between us and IBM. Our purpose in entering into thisEngagement Agreement was to limit the cash expenditures needed to pursue theSCO Litigation. The Engagement Agreement provides for the payment ofapproximately $26,000,000 for attorney fees in connection with the SCOLitigation through the end of the current litigation between us and IBM and theescrow of at least $5,000,000 for the payment of any expert, consulting andother expenses. As of July 31, 2005, we had paid $1,421,000 of expensesand the remaining $3,579,000 was classified as a component of restricted cash.

 

For future legal fees, the Engagement Agreementrequires us to pay to the Law Firms $2,000,000 per quarter for each successivequarter which began September 1, 2004 and will end December 1, 2005for a total amount of $12,000,000. In the nine months ended July 31, 2005,we made the quarterly payments for September 2004, December 2004, March 2005,and June 2005 for

 

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a total of $8,000,000. In addition, we are required topay expert, consulting and other expenses of the Law Firms in future periods. Thepayment of these fees has had and will continue to have a material impact onour cash position.

 

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 recovery from ourlitigation, our intellectual property licensing 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 aggregate recovery amounts received up to$350,000,000;

 

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

 

•      plus 20 percent of 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 (except for expert, consulting andother expenses as described above), in connection with the SCO Litigationthrough the end of the current litigation between us and IBM, including anyappeals.

 

We have entered intooperating leases for our corporate offices located in the United States and ourinternational sales offices. We have commitments under these leases that extendthrough fiscal year 2010.

 

The following tablesummarizes our contractual operating lease obligations and our requiredpayments to the Law Firms as of July 31, 2005: 

 
| ** **                   | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1 – 3 years** | ** ** | **More than  3 years** | ** ** |
|------------------------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|------------------------|------------|
|                         |       |      |       |                  |       |                 |       |                   |       |
| Operating lease  obligations |       | $         | 3,207,000  |                  | $          | 1,546,000            |       | $                      | 1,618,000  |   | $ | 43,000 |   |
| Payments to Law  Firms       |       | 4,000,000 |       | 4,000,000             |       | —               |       | —                 |       |
| Total obligations            |       | $         | 7,207,000  |                  | $          | 5,546,000            |       | $                      | 1,618,000  |   | $ | 43,000 |   |

 

As of July 31, 2005, we did not have anylong-term debt obligations, purchase obligations, other long-term liabilitiesor material capital lease obligations.

 

Our ability to cut costs to offset revenue declines inour UNIX business is limited because of contractual commitments to maintain andsupport our existing UNIX customers. This decline in our UNIX business may be accelerated if industrypartners withdraw their support as a result of our SCOsource initiatives. OurSCOsource initiatives may cause industry partners, developers and hardware andsoftware vendors to choose not to support or certify to our UNIX operatingsystem products. This would lead to an accelerated decline in our UNIX productsand services revenue. If our UNIX products and services revenue is lessthan expected, our liquidity will be adversely impacted.

 

We have issued shares and granted options under ourEquity Compensation Plans without complying with registration or qualificationrequirements under federal securities laws and the securities laws ofCalifornia, Utah and possibly other states. As a result, certain planparticipants have a right to rescind their purchases of shares under the EquityCompensation Plans or recover damages if they no longer own the shares or holdunexercised options, subject to applicable statutes of limitations, and we arecurrently preparing to conduct a rescission offer

 

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pursuant to which we will offer to purchaseapproximately 313,000 shares of common stock held by current and formerparticipants in the ESPP. On July 28, 2005, we filed a registrationstatement on Form S-1 with the SEC to register our repurchase ofapproximately 313,000 shares issued under the ESPP from current or formerparticipants in the ESPP. As of the date of the filing of this quarterly reporton Form 10-Q, the SEC has not declared the Form S-1 registrationstatement effective. Additionally, regulatory authorities may require us to payfines or they may impose other sanctions on us, and we may face other claims byparticipants other than rescission claims.

 

If our rescission offer is made and accepted by planparticipants holding shares acquired under the Equity Compensation Plans orotherwise entitled to recover damages from us in respect of such shares theyhave sold, or such plan participants otherwise make rescission claims againstus, we could be required to make aggregate payments to these plan participantsof up to $1,104,000, excluding interest and other possible fees, based uponshares outstanding under the Equity Compensation Plans as of July 31,2005.

 

We may also face additional rescission liability toplan participants holding unexercised stock options in California, Georgia andpossibly other states. Regulatory authorities may require us to pay fines orimpose other sanctions on us. We have not included in our proposed registrationstatement on Form S-1 the repurchase of shares to be issued upon theexercise of these stock options. Since any loss may be considered reasonablypossible but not estimable, we have not recorded a liability for thiscontingency.

 

We may also be required to pay interest and penaltiesup to statutory limits in connection with plan participants making rescissionclaims or in connection with any rescission offer. We believe that it isreasonably possible that we may be required to pay interest and penalties, butare not able to estimate an amount.

 

**Recent Accounting Pronouncements**

 

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial AccountingStandards No. 123R, “Share-Based Payment, an amendment ofFASB Statements Nos. 123 and 95,” which requires the measurement ofall employee share-based payments to employees, including grants of employeestock options, using a fair-value-based method and the recording of suchexpense in the consolidated statements of operations and comprehensive loss. Theaccounting provisions of SFAS No. 123R are effective for our firstfiscal year beginning after July 1, 2005, which will require us to adoptSFAS No. 123R for the three months ending January 31, 2006. Althoughwe are in the process of determining whether the adoption of SFAS No. 123Rwill result in future amounts that are similar to the amounts reported in ourpro forma disclosure under SFAS No. 123, adoption of SFAS No. 123Rcould have a material impact on our results of operations.

 

**ITEM 3.****            QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

*Foreign Currency Risk.*We haveforeign offices and operations in Europe and Asia. As a result, a portion ofour revenue is derived from sales to customers outside the United States. Ourinternational revenue is denominated in U.S. dollars, Euros and United KingdomPounds. Most of the operating expenses related to our foreign-based operationsare denominated in foreign currencies and therefore operating results areaffected by changes in the U.S. dollar exchange rate in relation to foreigncurrencies such as the Euro, among others. If the U.S. dollar weakens comparedto the Euro, our operating expenses for foreign operations will be higher whentranslated back into U.S. dollars. Our revenue can also be affected by generaleconomic

 

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conditionsin the United States, Europe and other international markets. Our results ofoperations may be affected in the short term by fluctuations in foreigncurrency exchange rates.

 

We have in the past utilized foreign currency forwardexchange contracts for market exposures of underlying assets and liabilities. Wedo not use forward exchange contracts for speculative or trading purposes. Ouraccounting policies for foreign exchange contracts are based on our designationof each contract. The criteria we use for designating each contract includesuch contract’s effectiveness in risk reduction and one-to-one matching offorward exchange contracts to underlying assets and liabilities. Gains andlosses on currency forward contracts that are firm commitments are deferred andrecognized in income in the same period that the underlying transactions aresettled. Gains and losses on currency forward contracts that are designated andeffective for existing transactions are recognized in income in the same periodas losses and gains on the underlying transactions are recognized and generallyoffset. Gains and losses on any instruments not meeting the above criteria arerecognized in income in the current period. As of July 31, 2005, we had nooutstanding instruments classified as hedges.

 

*Interest Rate Risk.*The primaryobjective of our cash management strategy is to invest available funds in amanner that assures maximum safety and liquidity and maximizes yield withinsuch constraints. We believe that a hypothetical movement in interest rates,either up or down, would not have a material adverse impact on our cash andcash equivalents and available-for-sale securities. We do not borrow money forshort-term investment purposes.

 

*Investment Risk.*We have investedin equity instruments of privately held and public companies in the technologyindustry for business and strategic purposes. Investments are accounted forunder the cost method if our ownership is less than 20 percent, and we are notable to exercise influence over operations. Our investment policy is toregularly review the assumptions and operating performance of these companiesand to record impairment losses when events and circumstances indicate thatthese investments may be impaired. As of July 31, 2005, our investmentsbalance was approximately $611,000 and was related to our investment in a 30percent owned Chinese company.

 

The stock market in general, and the market for sharesof technology companies in particular, has experienced price fluctuations. Inaddition, factors such as new product introductions by our competitors ordevelopments in our SCO Litigation may have a significant impact on the marketprice of our common stock. Furthermore, quarter-to-quarter fluctuations in ourresults of operations may have a significant impact on the market price of ourcommon stock. These conditions could cause the price of our common stock tofluctuate substantially over short periods of time.

 

**ITEM 4.****            CONTROLSAND PROCEDURES**

 

*Evaluation of disclosure controls and procedures.*Under the supervision and with the participation of our management, includingour Chief Executive Officer and Chief Financial Officer, we evaluated theeffectiveness of the design and operation of our disclosure controls and procedures(as defined in Rule 13a-15(e) under the Securities Exchange Act of1934 (the “Exchange Act”)). Based upon that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of the end of the periodcovered by this report, our disclosure controls and procedures were effective.

 

*Changes in internal control over financialreporting.* During the most recent fiscal quarter covered bythis report, there has been no change in our internal control over financialreporting (as defined in Rule 13a-15(f) and 15d-15(f) under theExchange Act) that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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**Forward-Looking Statements andFactors That May Affect Future Results and Financial Condition**

 

*With theexception of historical facts, the statements contained in Management’sDiscussion and Analysis of Financial Condition and Results of Operations are “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, which reflect our current expectations and beliefs regarding ourfuture results of operations, performance and achievements. These statementsare subject to risks and uncertainties and are based upon assumptions andbeliefs that may or may not materialize. These forward-looking statementsinclude, but are not limited to, statements concerning:*

 

•          Our belief that our UNIX business willcontinue to generate positive cash flow throughout the year ending October 31,2005;

 

•          Our belief that SCO OpenServer 6 will provideincreased system reliability, backward compatibility with existing applicationsand software, increased application and hardware support, integration withwidely used internet applications and increased system performance, and ourbelief that these enhancements will not have a direct impact on our short-termSCO OpenServer revenue and that they will help prolong OpenServer revenue infuture quarters;

 

•          Our intention to continue to pursue ourSCOsource initiatives for the year ending October 31, 2005;

 

•          Our belief that the future success of ourSCOsource initiatives will depend on our ability to protect our intellectualproperty;

 

•          Our intention to continue to maintain ourUNIX business and to pursue the SCO Litigation;

 

•          Our belief that our allowance for doubtfulaccounts receivable and bad debt expense will remain consistent with our priorexperience;

 

•          Our expectation that future levels ofservices revenue will depend in part on our ability to generate UNIX productsrevenue from new customers as well as the renewal of annual support andservices agreements from existing UNIX customers;

 

•          Our expectation for the three months ending October 31,2005 that the dollar amount of our cost of products revenue will be generallyconsistent to that generated in the three months ended July 31, 2005 andthat the cost of products revenue as a percentage of products revenue for thethree months ending October 31, 2005 will be generally consistent to thatincurred in the three months ended July 31, 2005;

 

•          Our expectation for the three months ending October 31,2005 that the dollar amount of our cost of services revenue will be generallyconsistent to that generated in the three months ended July 31, 2005 andthat the cost of services revenue as a percentage of services revenue for thethree months ending October 31, 2005 will be generally consistent to thatincurred in the three months ended July 31, 2005;

 

•          Our expectation for the three months ending October 31,2005 that the dollar amount of our sales and marketing expense will begenerally consistent to that incurred in the three months ended July 31,2005;

 

•          Our expectation for the three months ending October 31,2005 that the dollar amount of our research and development expense will begenerally consistent to that incurred in the three months ended July 31,2005;

 

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•          Our expectation for the three months ending October 31,2005 that the dollar amount of our general and administrative expense will begenerally consistent to that generated in the three months ended July 31,2005;

 

•          Our belief that we will use cash ofapproximately $3,250,000 to fund our SCO Litigation costs during the threemonths ending October 31, 2005;

 

•          Ourexpectation that our UNIX business will generate sufficient cash in the yearending October 31, 2005 to cover our internal costs related to ourSCOsource initiatives, and our belief that we will have sufficient cashresources to fund our operations through October 31, 2005; and

 

•          Ourexpectation that the dollar amount of our cost of SCOsource licensing for thethree months ending October 31, 2005 will be generally consistent to orslightly higher than the costs incurred in the three months ended July 31,2005.

 

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 success of our SCOsource initiatives,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 subsection entitled “Risk Factors” below. We also wish to advisereaders not to place any undue reliance on the forward-looking statementscontained in this report, which reflect our beliefs and expectations only as ofthe date of this report. We assume no obligation to update or revise theseforward-looking statements to reflect new events or circumstances or anychanges in our beliefs or expectations, other than as required by law.

 

**Risk Factors**

 

*Wedo not have a history of profitable operations.*

 

Our year ended October 31, 2003 was the firstfull year we were profitable in our operating history. Our profitability forthe year ended October 31, 2003 resulted primarily from our SCOsourceinitiatives. For the year ended October 31, 2004, we incurred a loss fromoperations of $28,573,000 and our accumulated deficit as of October 31,2004 was $224,216,000. For the nine months ended July 31, 2005 we incurreda loss from operations of $8,307,000 and as of July 31, 2005 had an accumulateddeficit of $231,511,000.

 

If our revenue from the sale of our UNIX products andservices continues to decline, we will need to further reduce operatingexpenses to generate positive cash flow. We may not be able to further reduceoperating expenses without damaging our ability to support our existing UNIXbusiness. Additionally, we may not be able to achieve profitability throughadditional cost-cutting actions.

 

Our UNIX products and services revenue has declinedover the last several years primarily as a result of increased competition fromalternative operating systems, particularly Linux. In our quarterly results ofoperations, we recognize revenue from agreements for support and maintenancecontracts and other long-term contracts that have been previously invoiced andare included in deferred revenue. Our future UNIX revenue may be adverselyimpacted and may continue to decline if we are unable to replenish thesedeferred revenue balances with long-term maintenance and support contracts orreplace them with other sustainable revenue streams. If we are unable togenerate positive cash flow and profitable operations, our business will beadversely impacted.

 

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*We may not prevail in our SCO Litigation, which mayadversely affect our business.*

 

We continue to pursue our SCO Litigation and believein the merits of our cases. In our action against IBM, we seek damages forclaims generally relating to our allegation that IBM has inappropriately usedand distributed our UNIX source code and derivative works in connection withits efforts to promote the Linux operating system. IBM has responded to ourclaims and brought counterclaims against us asserting generally that we do nothave the right to assert claims based on our ownership of UNIX intellectualproperty against IBM or others in the Linux market. Discovery is continuing inthe case, and several motions are currently pending before the court. If we donot prevail in our action against IBM, or if IBM is successful in itscounterclaims against us, our business and results of operations would bematerially harmed and we may not be able to continue in business. Thelitigation with IBM and others will be costly, and our costs for legal feeshave been and will continue to be substantial and may exceed our capitalresources. 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.

 

As a result of our SCO Litigation and our otherSCOsource initiatives, several participants in the Linux industry and othersaffiliated with IBM or sympathetic to the Linux movement have taken actionsattempting to negatively affect our business and our SCOsource efforts. Linuxproponents have taken a broad range of actions against us, including, forexample, attempting to influence participants in the markets in which we sellour products to reduce or eliminate the amount of our products and servicesthey purchase from us. We expect that similar efforts likely will continue. Thereis a risk that participants in our marketplace will negatively view our actionagainst IBM, Novell, DaimlerChrysler and AutoZone and our other SCOsourceinitiatives, and we may lose support from such participants. Any of theforegoing could adversely affect our position in the marketplace, our resultsof operations and our stock price and our ability to stay in business.

 

As a further response to our SCOsource initiatives andclaim that our UNIX source code and derivative works have inappropriately beenincluded in Linux, Novell has publicly asserted its belief that it owns certaincopyrights in our UNIX source code, and it has filed 15 copyright applicationswith the United States Copyright Office related to UNIX. Novell also claimsthat it has a license to UNIX from us and the right to authorize its customersto use UNIX technology in its internal business operations. Specifically,Novell has also claimed to have retained rights related to legacy UNIX SVRxlicenses, including the license with IBM. Novell asserts it has the right totake action on behalf of SCO in connection with such licenses, includingtermination rights. Novell has purported to veto our termination of the IBM,Sequent and SGI licenses. We have asserted that we obtained the UNIX business,source code, claims and copyrights when we acquired the assets and operationsof the server and professional services groups from The Santa Cruz Operation(now Tarantella, Inc.) in May 2001, which had previously acquired allsuch assets and rights from Novell in September 1995 pursuant to an assetpurchase agreement, as amended. In January 2004, in response to Novell’sactions, we brought suit against Novell for slander of title seeking relief forNovell’s alleged bad faith effort to interfere with our copyrights and contractrights related to our UNIX source code and derivative works and our UnixWareproducts. Novell is seeking dismissal of this case.

 

Notwithstanding our assertions of full ownership ofUNIX-related intellectual property rights, as set forth above, includingcopyrights, and even if we are successful in our legal action against Novelland end users such as AutoZone and DaimlerChrysler, the efforts of Novell and theother Linux proponents described above may cause further damage to our businessincluding our ability to monetize our UNIX assets. These efforts of Linuxproponents also may increase the negative view some participants in ourmarketplace have regarding our SCO Litigation and regarding our SCOsourceinitiatives and may contribute to creating confusion in the marketplace aboutthe validity of our claim that the unauthorized use of our UNIX source code andderivative

 

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works in Linux infringes on our copyrights. Increasednegative perception and potential confusion about our claims in our marketplacecould impede our continued pursuit of our SCOsource initiatives and negativelyimpact our business.

 

*Our Engagement Agreement with theLaw Firms will require us to spend a significant amount of cash during the yearending October 31, 2005 and could harm our liquidity position.*

 

As of July 31, 2005, we had a total of$12,602,000 in cash and cash equivalents and available-for-sale securities andan additional $3,579,000 of restricted cash to be used in our operations andpursue the SCO Litigation. As a result of the Engagement Agreement between usand the Law Firms, for the three months ending October 31, 2005 we anticipatespending approximately $3,250,000 to fund our SCO Litigation costs. We expectthat our UNIX business will generate sufficient cash for the year ending October 31,2005 to cover our internal costs related to our SCOsource initiatives and SCOLitigation. However, if our UNIX business does not generate cash or we spendadditional cash on the SCO Litigation or additional matters, our cash positionwould be negatively impacted, and our ability to pursue our UNIX businessobjectives and our SCO Litigation could be harmed.

 

*Ourfuture SCOsource licensing revenue is uncertain.*

 

We initiated the SCOsource licensing effort in theyear ended October 31, 2003 to review the status of UNIX licensing andsublicensing agreements. This effort resulted in the execution of twosignificant vendor license agreements and generated $25,846,000 in revenue. Duringthe year ended October 31, 2004, our SCOsource licensing revenue declinedsignificantly and was only $829,000 and during the nine months ended July 31,2005 SCOsource licensing revenue was $132,000. Due to 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 from this source, it may be sporadic andfluctuate from quarter to quarter. Our SCOsource initiatives are unlikely toproduce stable, predictable revenue for the foreseeable future. Additionally,the success of these initiatives may depend on the strength of our intellectualproperty rights and contractual claims regarding UNIX, including the strengthof our claim that unauthorized UNIX source code and derivatives are prevalentin Linux.

 

*Wemay lose the support of industry partners leading to an accelerated decline inour UNIX products and services revenue.*

 

Thedecline in our UNIX business and our SCOsource initiatives 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 anaccelerated decline in our UNIX products and services revenue and wouldadversely impact our results of operations and liquidity.

 

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

 

In August 2003,Red Hat brought a lawsuit against us asserting that the Linux operating systemdoes not infringe on our UNIX intellectual property rights and seeking adeclaratory judgment for non-infringement of copyrights and no misappropriationof trade secrets. In addition, Red Hat claims we have engaged in falseadvertising in violation of the Lanham Act, deceptive trade practices, unfaircompetition, tortious interference with prospective business opportunities, andtrade libel and disparagement. Although this case is currently stayed pendingthe resolution of our suit against IBM, we intend to vigorously defend thisaction. However, if Red Hat is successful in its claim against us, our businessand results of operations could be materially harmed.

 

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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.

 

*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 potential for significant fluctuations in ourSCOsource licensing revenue in any particular period, you should not rely oncomparisons of our results of operations as an indication of futureperformance.

 

Factorsthat may affect our results include:

 

•              ourability to successfully negotiate and complete licensing and other agreementsrelated to our intellectual property;

 

•              theinterest level of resellers in recommending our UNIX business solutions to endusers;

 

•              theintroduction, development, timing, competitive pricing and market acceptance ofour products and services and those of our competitors;

 

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

 

•              resultsof, or developments in our SCO Litigation;

 

•              changesin business attitudes toward UNIX as a viable operating system compared toother competing systems, especially Linux;

 

•              thecontingency and other legal fees we may pay to the Law Firms representing us inour efforts to establish our intellectual property rights; and

 

•              changesin attitudes of customers and partners due to the decline in our UNIX businessand our aggressive position against the inclusion of our UNIX code andderivative works 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 in these regions typically occur during thesummer months.

 

As aresult 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 todecline. If revenue falls below our expectations, and we are unable to quicklyreduce our spending in response, our operating results will be lower thanexpected. Our stock price may fall in response to these events.

 

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*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.*

 

In theoperating system market, our competitors include IBM, Red Hat, Novell, Hewlett-Packard,Sun, Microsoft and other Linux distributors. These and other competitors areaggressively pursuing the current UNIX operating system market. Many of thesecompetitors have access to substantially greater resources than we do. Themajor competitive alternative to our UNIX products is Linux. The expansion ofour competitors’ offerings may restrict the overall market available for ourUNIX products, including some markets where we have been successful in thepast.

 

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 our products to meet these evolving needs,we may not remain competitive and be able to grow our business. Additionally,because technological advancement in the UNIX operating system market andalternative operating system markets is progressing at an advanced pace, wewill have to develop and introduce enhancements to our existing products andany new products on a timely basis to keep pace with these developments,evolving industry standards and changing customer requirements. Our failure tomeet any of these and other competitive pressures may render our existingproducts and services obsolete, which would have an adverse impact on ourrevenue and operations.

 

Thesuccess of our UNIX business will depend on the level of commitment andcertification we receive from industry partners and developers. In recentyears, we have seen hardware and software vendors as well as software developersturn their certification and application development efforts toward Linux andelect not to continue to support or certify to our UNIX operating systemproducts. If this trend continues, our competitive position will be adverselyimpacted and our future revenue from our UNIX business will decline. Thedecline in our UNIX business may be accelerated if industry partners withdrawtheir support from us for any reason, including our SCOsource initiatives.

 

*Ifthe market for UNIX continues to contract, our business will be harmed.*

 

Ourrevenue from the sale of UNIX products has declined over the last severalyears. This decrease in revenue has been attributable primarily to increasedcompetition 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 adoption cycle for operating system purchases andthe long sales cycle of our operating system products, we may not be able toreverse these revenue declines quickly.

 

*Werely on 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 developedwith resellers allow us to offer our products and services to a much largercustomer base than we would otherwise be able to reach through our own directsales and marketing efforts. Some solution providers also purchase solutionsthrough our resellers, and we anticipate they will continue to do so. Becausewe usually sell indirectly through resellers, we cannot control therelationships through which resellers, solution providers or equipmentintegrators purchase our products. In turn, we do

 

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not control thepresentation of our products to end users. Therefore, our sales could beaffected by disruptions in the relationships between us and our resellers,between our resellers and solution providers, or between solution providers andend users. Also, resellers and solution providers may choose not to emphasizeour products to their customers. Any of these occurrences could diminish theeffectiveness of our distribution channel and lead to decreased sales.

 

*OurEngagement Agreement with the Law Firms representing us in our SCO Litigationmay reduce our ability to raise additional financing.*

 

OurEngagement Agreement with the Law Firms could inhibit our ability to raiseadditional funding if needed. Although under the Engagement Agreement ourobligations to the Law Firms are limited to approximately $26,000,000 relatedto certain previously accrued and all future attorney fees and the escrow of$5,000,000 for the payment of any expert, consulting and other expenses topursue the SCO Litigation, the agreement provides that the Law Firms willreceive a contingency fee that may range from 20 to 33 percent of theproceeds from specified events related to the protection of our intellectualproperty rights. Events triggering a contingency fee may include settlements orjudgments related to the SCO Litigation, certain licensing fees, subject tocertain exceptions, and a sale of our company. Future payments payable to theLaw Firms under this arrangement will be significant. The Law Firms’ right toreceive such contingent payments could cause prospective investors to choosenot to invest in our company or limit the price at which new investors would bewilling to provide additional funds to our company.

 

*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.*

 

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:

 

•              potentialloss of developed technology through piracy, misappropriation, or more lenientlaws regarding intellectual property protection;

 

•              impositionof governmental controls, including trade restrictions and other taxrequirements;

 

•              fluctuationsin currency exchange rates and economic instability;

 

•              longerpayment cycles 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 foreigncountries, our effective income tax rate is increased.

 

InLatin America and Asia in particular, several countries have suffered and maybe especially susceptible to recessions and economic instability, which maylead to increased governmental ownership or regulation of the economy, higherinterest rates, increased barriers to entry such as higher tariffs and taxes,and reduced demand for goods manufactured in the United States, resulting inlower revenue.

 

Duringthe three months ended July 31, 2004, our Indian office was given awithholding tax assessment from the Government of India Income Tax Department. TheTax Department assessed a 15 percent withholding tax on certain revenuetransactions in India that the Tax Department deemed royalty revenue under theIncome Tax Act. We have filed an appeal with the Tax

 

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Department and believethat our packaged software does not qualify for treatment as royalties andtherefore would not be subject to withholding tax. However, we may beunsuccessful in our appeal against the Tax Department and be obligated to paythe assessed taxable amounts. If other countries in which we have internationaloperations, such as India, continue to develop and begin enforcing their taxregimes, we may be subject to withholding or other taxes.

 

*Ifwe are unable to retain key personnel in an intensely competitive environment,our operations could be adversely affected.*

 

Weneed to retain our management, technical, and support personnel. Competitionfor qualified professionals in the software industry is intense, and departuresof existing personnel could be disruptive to our business and might result inthe departure of other employees. The loss or departure of any officers or keyemployees could harm our ability to implement our business plan and couldadversely affect our operations. Our future success depends to a significantextent on the continued service and coordination of our management team,particularly Darl C. McBride, our President and Chief Executive Officer.

 

*We have issued certain shares andoptions under our Equity Compensation Plans without complying with registrationor qualification requirements under federal and state securities laws, and, asa result, we may incur rescission liability for such shares and options and mayface additional potential claims under federal and state securities laws.*

 

We have issued certainshares and options granted under our Equity Compensation Plans withoutcomplying with registration or qualification requirements under federalsecurities laws and the securities laws of California, Utah and possibly otherstates. As a result, certain plan participants that have acquired shares issuedunder the Equity Compensation Plans have rescission rights against us, subjectto applicable statutes of limitations, and we are, subject to obtainingrequired regulatory approvals, currently preparing to conduct a rescissionoffer to certain of such plan participants. Additionally, regulatoryauthorities may require us to pay fines or they may impose other sanctions onus, and we may face other claims by plan participants other than rescissionclaims.

 

If ourpossible rescission offer is made and accepted by plan participants holdingshares acquired under the Equity Compensation Plans or otherwise entitled torecover damages from us in respect of such shares they have sold we could beliable to make aggregate payments to these plan participants of up to$1,104,000, excluding interest and other possible fees, based upon sharesoutstanding under the Equity Compensation Plans as of July 31, 2005.

 

We mayface additional rescission liability to plan participants holding unexercisedstock options in California, Georgia, and possibly other states. Additionally,federal securities laws do not provide that a rescission offer will terminate apurchaser’s right to rescind a sale of stock that was not registered asrequired under federal law.

 

*Our stock price is volatile.*

 

The trading price for our common stock has beenvolatile, ranging from a low closing sales price of $1.09 in mid-February 2003,to a high closing sales price of $20.50 per share in October 2003, to acurrent sales price of $4.23 on September 8, 2005. The share price haschanged dramatically over short periods. We believe that the changes in ourstock price are affected by changing public perceptions concerning the strengthof our intellectual property claims and other 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 subjectto such volatility and, consequently, is subject to significant risk.

 

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

 

As of August 31,2005, we have issued and outstanding options to purchase up to approximately 3,871,000shares of common stock with an average exercise price of $4.28 per share. Theexistence of such rights to acquire common stock at fixed prices may prove ahindrance to our efforts to raise future equity and debt funding, and theexercise of such rights will dilute the percentage ownership interest of ourstockholders and may dilute the value of their ownership. The possible futuresale of shares issuable on the exercise of outstanding options could adverselyaffect the prevailing market price for our common stock. Further, the holdersof the outstanding rights may exercise them at a time when we would otherwisebe able to obtain additional equity capital on terms more favorable to us.

 

*Theissuance of common shares to BayStar may have an adverse impact on the marketvalue of our stock and the existing holders of our common stock.*

 

Wepreviously had an effective registration statement on Form S-3 relating tothe sale or distribution by BayStar as a selling stockholder of the 2,105,263shares of common stock issued to BayStar in connection with our repurchasecompleted in July 2004 of all Series A-1 shares previously held byBayStar. When we failed to file our Annual Report on Form 10-K for theyear ended October 31, 2004 in a timely fashion, we became ineligible touse Form S-3, our registration statement ceased to be effective andBayStar’s ability to resell shares pursuant to that registration statementterminated. Consequently, we prepared a post-effective amendment to Form S-3on Form S-1 for the resale of BayStar’s shares. When that registrationstatement was declared effective by the SEC, BayStar was again able to resellits shares. We will not receive any proceeds from the sales of the shares coveredby such registration statement. The shares that may be sold or distributedpursuant to such registration statement represent approximately 6 percent ofour outstanding common stock. The sale of the block of stock covered by suchregistration statement, or even the possibility of its sale, may adverselyaffect the trading market for our common stock and reduce the price availablein that market.

 

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

 

Our stock has attracted the interest of shortsellers. The activities of short sellers could further reduce the price of ourstock or inhibit increases in our stock price.

 

*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. The board of directors can designate newseries of preferred stock without the approval of the holders of our commonstock. 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, theissuance of preferred stock could make it more difficult for a third party toacquire a majority of our outstanding 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.*

 

Wehave adopted a Stockholder Rights Plan (“Rights Plan”). The power given to theBoard of Directors by the Rights Plan may make it more difficult for a changeof control of our company to occur or for the Company to be acquired when theacquisition is opposed by our Board of Directors.

 

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| **PART II.** | **OTHER INFORMATION** |
|-------------------|-----------------------|
|              |                  |
| **ITEM 1.**       | **LEGAL PROCEEDINGS** |

 

Thefollowing includes updated information relating to certain of our materiallegal proceedings as previously reported in our annual report on Form 10-Kfor the year ended October 31, 2004 and our quarterly reports on Form 10-Qfor the three-month periods ended January 31, 2005 and April 30,2005.

 

*IBM Corporation*

 

On or about March 6,2003, we filed a complaint against IBM Corporation (“IBM”). This action ispending in the United States District Court for the District of Utah, under thetitle The SCO Group, Inc. v. International Business Machines Corporation,Civil No. 2:03CV0294. This action includes, among other things, our claimagainst IBM for breach of contract, copyright infringement, tortiousinterference, and unfair competition relating to IBM’s alleged use and distributionof information concerning the UNIX source code and derivative works inconnection with its efforts to promote the Linux operating system. IBM hasresponded to our claims and made counterclaims against us.

 

Following a hearing on October 19,2004, on January 19, 2005, the United States Magistrate Judge overseeingthe discovery in the case issued an order granting in part and denying in partdiscovery applications that we had made. The Court ordered IBM to produce muchof the information, including source code, revision information, and programmercontribution information, that we had previously requested. The court alsostruck the Amended Scheduling Order and directed the parties to submit aproposed amended scheduling order to the Court, which both parties have done. TheDistrict Court heard argument on the proposed schedules on April 21, 2005.On July 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.

 

In response to theMagistrate Court’s Order, IBM filed, on February 11, 2005, a Motion forReconsideration of the portion of the January 19 Order that required IBMto produce programmer-contribution information for 3,000 people. IBM alsofiled, on March 9, 2005, a Motion for a 45-day Extension of Time to Complywith the Court’s January 19 Order as it applies to materials that are notthe subject of IBM’s above-referenced Motion for Reconsideration. On March 16,2005, the Court granted the extension and entered an order requiring IBM toproduce those materials by May 3, 2005. With respect to the materialscovered by IBM’s Motion for Reconsideration, the Court granted IBM’s request tostay its discovery obligations pending the Court’s resolution of its motion.

 

On April 19, 2005,the Magistrate Court ruled on IBM’s reconsideration motion. The Court declinedto strike its prior requirement that IBM produce documents from the files ofthe 3,000 individuals who made the most contributions and changes to thedevelopment of AIX and Dynix. The Court reiterated its requirement that IBMproduce programmer’s notes, design documents, white papers, comments and notes,contact information, specific changes made to code, and all relevantnon-privileged documents from the files of the 100 individuals who made themost contributions and changes to the development of AIX and Dynix; ordered IBMto provide a privilege log for any documents withheld from the files of those100 individuals; and required IBM to comply within 90 days. The Court deferredthe remainder of IBM’s required production pending our review of theabove-described discovery. The Court also reiterated that IBM is required toproduce all non-public Linux contribution information and directed IBM toproduce all such information within 75 days.

 

On February 9, 2005,the United States District Judge ruled on several pending dispositive motions. TheCourt denied the three motions for partial summary judgment that IBM

 

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had filed on our contract claims, on IBM’seighth counterclaim for copyright infringement, and on IBM’s tenth counterclaimfor a declaration of non-infringement of our copyrights. The Court denied eachof those motions without prejudice to IBM’s renewing or refiling the motionsafter discovery is complete. The Court also denied our motion to stay ordismiss IBM’s tenth counterclaim. The Court ordered that no further dispositivemotions could be filed until the close of discovery, except by stipulation ofthe parties, and vacated its prior order, dated September 30, 2004, to theextent that order had granted permission to file dispositive motions before theclose of discovery.

 

On January 12, 2005,we filed a Motion to Compel IBM to produce IBM CEO Samuel J. Palmisano forDeposition. The Court heard argument on that motion on April 21, 2005. On July 1,2005, the Court issued an order granting our motion and ordered IBM to produce Mr. Palmisanofor a four-hour deposition in New York. The Court found that Mr. Palmisanocould have unique personal knowledge related to the claims in the case.

 

The parties have fullybriefed this motion, and the Court heard argument on that motion on April 21,2005. The Court took the matter under advisement. The parties have also nowfully briefed our December 23, 2004 Renewed Motion to Compel Discovery,which seeks to compel IBM’s compliance with prior Court orders relating to IBM’sobligation (1) to produce all documents pertaining to Linux from the filesof high-level IBM executives and board members; and (2) to producewitnesses to testify on several topics in two deposition notices that SCO hasserved on IBM. The Court has not set a hearing date for this motion.

 

On September 6,2005, we filed a renewed motion to compel IBM to produce information relatingto IBM’s work on the source code that IBM contributed to Linux where suchinformation is in IBM’s hands and not publicly available.

 

In addition to thematerials that have been publicly filed with the Court, certain information hasbeen filed under seal in accordance with the protective order entered in thecase. On November 30, 2004, a third party moved to intervene in the casefor the purpose of challenging the sealing of certain documents filed with theCourt, and additional groups subsequently joined in that motion. Followingargument on April 26, 2005, by Order dated April 28, 2005, the Courtdenied the intervention motion. In its Order, the Court set forth variousprocedures to minimize the risk that documents would be improperly filed underseal. The parties have since directed the Clerk of the Court to unseal numerouspreviously unsealed filings.

 

We have also filed amotion for leave to file a third amended complaint in order to assert anadditional copyright claim against IBM in the case. The Court heard argument onthat fully briefed motion on April 21, 2005 and took the matter underadvisement. In its July 1 order, the Court denied our motion. The Courtfirst allowed IBM to narrow the scope of its Ninth Counterclaim, and havingdone so concluded that our proposed new claim would expand the litigation anddelay its resolution. The Court also opined that it appears that we or ourpredecessor-in-interest either knew or should have known about the conduct atissue in the new claim before we filed our original Complaint. We thereforewill not pursue additional copyright remedies in this case regarding IBM’salleged misuse of our code in its AIX product as set forth in the proposedamended complaint. We have explained in briefing and argument before the Court,however, that the predicate facts of the proposed copyright claim are alreadyin the case as part of other claims.

 

Discoveryis continuing in the case and we are reviewing that discovery. We are reviewingthat discovery and currently anticipate that we will seek to amend ourcomplaint in the near future in order to assert additional claims against IBM.

 

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*Novell, Inc.*

 

On January 20, 2004, we filed suit in Utahstate court against Novell, Inc. (“Novell”) for slander of title seekingrelief for its alleged bad faith effort to interfere with our ownership ofcopyrights related to UNIX source code and derivative works and our UnixWareproduct. The case, after removal to federal court, is pending in the UnitedStates District Court for the District of Utah under the caption The SCO Group, Inc.v. Novell, Inc., Civil No. 2:04CV00139. In the lawsuit, we requestedpreliminary and permanent injunctive relief as well as damages. Through theseclaims, we seek to require Novell to assign to us all copyrights that webelieve Novell has wrongfully registered, prevent Novell from representing anyownership interest in those copyrights and require Novell to retract orwithdraw all representations it has made regarding its purported ownership ofthose copyrights.

 

Novell has filed a second motion to dismiss claiming,among other things, that Novell’s false statements were not uttered with maliceand are privileged under the law. The Court heard the argument on the motion onMay 25, 2005. On June, 27, 2005, the Court issued an order denying Novell’smotion.

 

On July 29, 2005, Novell filed its Answer andCounterclaims against us, asserting counterclaims for our alleged breaches ofthe Asset Purchase Agreement between Novell and our predecessor-in-interest,The Santa Cruz Operation, Inc., for slander of title, restitution/unjustenrichment, and accounting, and for declaratory relief regarding Novell’salleged rights under the Asset Purchase Agreement. By stipulation of theparties and approval of the Court, our response to Novell’s Answer andCounterclaims was due and filed on September 12, 2005.

 

*AutoZone, Inc.*

 

On or about March 2, 2004, we brought suitagainst AutoZone, Inc. (“AutoZone”) for its alleged violations of our UNIXcopyrights through its use of Linux. The lawsuit alleges copyright infringementby AutoZone by, among other things, running versions of the Linux operatingsystem that contain proprietary material from UNIX System V. The lawsuit, filedin United States District Court in Nevada, requests injunctive relief againstAutoZone’s further use or copying of any part of our copyrighted materials andalso requests damages as a result of AutoZone’s infringement in an amount to beproven at trial. In response to AutoZone’s motion to transfer the case toTennessee or stay the case, the federal court in Nevada granted AutoZone’smotion to stay the case, with 90-day status reports to the court, and deniedwithout prejudice AutoZone’s motion to transfer the case to Tennessee. Thefederal court allowed the parties to take limited expedited discovery relatingto the issue of preliminary injunctive relief, which discovery was concluded inMay 2005.

 

We have concluded the initial discovery allowed by thecourt and filed our report with the Court on May 27, 2005. Contrary toAutoZone’s own statements to the court, we found through discovery, includingdepositions and other admissions of AutoZone, many instances of copying ofprograms containing SCO OpenServer code. AutoZone has represented that it hasnow removed all of the SCO code and proprietary information it copied or usedin its migration to Red Hat Linux. Because AutoZone represents it has removedor otherwise is not using SCO code and proprietary information, we currently donot intend to move for a preliminary injunction. AutoZone does not admit thatit violated our rights or caused us damage in that migration process, which arestill points of dispute between the parties. Given the stay issued by the Courtin the case, we reserve the right to pursue infringement and damages in thefuture based on these issues and other issues stayed by the Court.

 

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| **ITEM  2.** | **UNREGISTERED SALES OF EQUITY  SECURITIES AND USE OF PROCEEDS** |
|--------------|------------------------------------------------------------------|

 

**Unregistered Sales of Equity Securities**

 

As described elsewhere in this Form 10-Q, wehave issued shares and granted options under our Equity CompensationPlans without complying with registration or qualification requirements underfederal securities laws and the securities laws of California, Utah andpossibly other states. As a result, certain plan participants have a right torescind their purchases of shares under the Equity Compensation Plans orrecover damages if they no longer own the shares or hold unexercised options,subject to applicable statutes of limitations. Additionally, regulatoryauthorities may require us to pay fines or impose other sanctions on us. We arecurrently in the process, subject to obtaining required regulatory approvals,of conducting a rescission offer to certain plan participants that hold sharesacquired under the ESPP or that otherwise are entitled to recover damages fromus in respect of such shares they have sold.

 
| **ITEM 4.** | **SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS** |
|-------------|----------------------------------------------------------|

 

Thefollowing matter was submitted to and approved by our stockholders at ourannual meeting held June 28, 2005:

 

1.             To electeight members to the Board of Directors to serve until their successors havebeen appointed. All directors were elected with Ralph J. Yarro III receiving11,119,000 votes in favor and 475,000 votes withheld, Edward E. Iacobuccireceiving 11,440,000 votes in favor and 155,000 votes withheld; R. Duff Thompsonreceiving 11,433,000 votes in favor and 161,000 votes withheld; Darcy G. Mottreceiving 11,066,000 votes in favor and 529,000 votes withheld; Darl C. McBridereceiving 11,484,000 votes in favor and 110,000 votes withheld; Daniel W.Campbell receiving 11,484,000 votes in favor and 110,000 votes withheld; OmarT. Leeman receiving 11,495,000 votes in favor and 99,000 votes withheld; and J.Kent Millington receiving 11,489,000 votes in favor and 105,000 votes withheld.

 
| **ITEM 6.** | **EXHIBITS** |
|-------------|--------------|

 

(a)           Exhibits

 

3.1           Amendedand Restated Certificate of Incorporation of Caldera International, Inc.(incorporated by reference to Exhibit 3.1 to SCO’s Registration Statementon Form 8-A12G/A (File No. 000-29911)).

 

3.2           Certificateof Amendment 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)).

 

3.3           Certificateof Amendment to Amended and Restated Certificate of Incorporation regardingchange of name to The SCO Group, Inc. (incorporated by reference to Exhibit 3.3to SCO’s Registration Statement on Form 8A12G/A (File No. 000-29911)).

 

3.4           Amendedand Restated Bylaws (incorporated by reference to Exhibit 3.4 to SCO’sRegistration Statement on Form 8-A12G/A (File No. 000-29911)).

 

3.5           Certificateof Designation for Series A-1 Convertible Preferred Stock (incorporated byreference to Exhibit 4.1 to SCO’s Current Report on Form 8-K filed onFebruary 9, 2004 (File No. 000-29911)).

 

3.6           Certificateof Correction correcting the Certificate of Designation for Series A-1Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 toSCO’s Current Report on Form 8-K filed on February 9, 2004 (File No. 000-29911)).

 

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10.1         Form Noticeof Grant of Stock Options for 2004 Omnibus Stock Incentive Plan (incorporatedby reference to Exhibit 99.1 to the Registrant’s Current Report on Form 8-Kfiled on July 15, 2005 (File No. 000-29911)).

 

10.2         Summary Sheetof Compensation for Directors (incorporated by reference to Exhibit 99.2 toSCO’s Current Report on Form 8-K filed on July 5, 2005 (File No. 000-29911)).

 

31.1         Certificationof Darl C. McBride, President and Chief Executive Officer, pursuant to Rule 13a-14(a) ofthe Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-OxleyAct of 2002.

 

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

 

32.1         Certificationof 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 906of the Sarbanes-Oxley Act of 2002.

 

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

 

**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: September 13,  2005 | THE SCO GROUP,  INC. |
|--------------------------------|----------------------|
|                           |                 |   |
|                           | By:                  | /s/   Bert Young |   |
|                           |                 | Bert Young |
|                           |                 | Duly Authorized  Officer and |
|                           |                 | Chief Financial  Officer |
|                           |                 | (Principal  Financial and |
|                           |                 | Accounting  Officer) |
|                                |                      |  |  |  |

 

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**EXHIBIT INDEX**

 
| **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)). |
|        |       |                                                                                                                                                                                                                                                                                |
| 10.1        |       | Form Notice  of Grant of Stock Options for 2004 Omnibus Stock Incentive Plan (incorporated  by reference to Exhibit 99.1 to SCO’s Current Report on Form 8-K  filed on July 15, 2005 (File No. 000-29911)).                                           |
|        |       |                                                                                                                                                                                                                                                                                |
| 10.2        |       | Summary Sheet of  Compensation for Directors (incorporated by reference to Exhibit 99.2 to  SCO’s Current Report on Form 8-K filed on July 5, 2005 (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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