**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q/A**

 

**Amendment No. 1**

 

**(Markone)**
| **ý**                                            | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF**  |
|-------------------------------------------------------|------------|--------------------------------------------------------------------|
| *** ***                                          | ** ** | **THE SECURITIES EXCHANGE ACT OF 1934**                            |
|                                                  |       |                                                               |
| **For the quarterly period ended July 31, 2004** |
| ** **                                            | ** ** | ** **                                                         |
| **OR**                                                |
|                                                  |       |                                                               |
| **o**                                                 | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF** |
| ** **                                            | ** ** | **THE SECURITIES EXCHANGE ACT OF 1934**                            |

 

**For thetransition period from                      to                     **

 

**Commission file number 0-29911**

 

**THE SCO GROUP, INC.**

(Exact name of registrant as specified in its charter)

 
| **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 and zip code)     |
|                                                      |       |                                    |
| **(801) 765-4999**                                        |
| (Registrant’s telephone number, including area code) |

 

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 tofiling requirements for the past 90 days.

 

YES ý NO o

 

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

 

YESo NO ý

 

*As of September 13, 2004, there were 17,484,473 sharesof the Registrant’s common stock, $0.001 par value per share, outstanding.*

 

 

----

 

**Explanatory Note**

 

The purpose of thisAmendment No. 1 to the Quarterly Report on Form 10-Q/A is to restatethe Company’s condensed consolidated financial statements for the three andnine months ended July 31, 2004 (the “Financial Statements”) and to modifythe related disclosures.  Please see Note2 to the Financial Statements included in the amended Form 10-Q.

 

The restatement arosefrom the Company’s determination that it has issued shares of its common stockunder its equity compensation plans without complying with the registrationrequirements of federal and applicable state securities laws.  As a result, the holders of such shares havea rescission right.  The Company hasdetermined that amounts received by the Company upon purchase of such sharesmust be reclassified from permanent equity to temporary equity.  The Company will also reclassify an amountfrom cash and cash equivalents to available-for-sale securities to reflect theappropriate classification of certain auction rate securities.

 

Thisamended Form 10–Q/A does not attempt to modify or update any otherdisclosures set forth in the original Form 10–Q, except as required toreflect the effects of the restatement as described in Note 2 to the FinancialStatements included in the amended Form 10–Q/A. Additionally, this amendedForm 10–Q/A, except for the restatement information, speaks as of thefiling date of the original Form 10-Q and does not update or discuss anyother Company developments after the date of the original filing.  All information contained in this amended Form 10–Q/Aand the original Form 10–Q is subject to updating and supplementing asprovided in the periodic reports that the Company has filed and will file afterthe original filing date with the Securities and Exchange Commission.

 

2

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**The SCO Group, Inc.**

 

**Tableof Contents**

 
|          |                                                                                                                                              |   |
|---------------|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| PART I.  | FINANCIAL INFORMATION                                                                                                                             |   |
| Item 1.       | Financial Statements                                                                                                                              |   |
|          | Condensed Consolidated  Balance Sheets as of July 31, 2004 and October 31, 2003                                                         |   |
|          | Condensed  Consolidated Statements of Operations and Comprehensive Income (Loss) for the  three and nine months ended July 31, 2004 and 2003 |   |
|          | Condensed  Consolidated Statements of Cash Flows for the nine months ended July 31,  2004 and 2003                                           |   |
|          | 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 6.       | Exhibits                                                                                                                                          |   |
| Item 7.       | Signatures                                                                                                                                        |   |

 

3

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

 

**CONDENSED CONSOLIDATED BALANCESHEETS**

**(unaudited, in thousands)**

 
| ** **                                                                                                              | ** ** | **July 31,  2004**      | ** ** | **October 31,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|----------------------------|------------|
| ** **                                                                                                              | ** ** | **(Restated -  see Note 2)** | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                              | ** ** | ** **                   | ** ** | ** **                 | ** ** |
|                                                                                                                    |       |                         |       |                       |       |
| CURRENT ASSETS:                                                                                                         |       |                         |       |                       |       |
| Cash and cash  equivalents                                                                                              |       | $                            | 5,582      |                       | $          | 64,428 |   |
| Restricted cash                                                                                                         |       | 13,506                       |       | 2,025                      |       |
| Available-for-sale  securities                                                                                          |       | 37,445                       |       | 4,095                      |       |
| Accounts  receivable, net of allowance for doubtful accounts of $126 and $230,  respectively                            |       | 5,954                        |       | 9,282                      |       |
| Other current  assets                                                                                                   |       | 2,466                        |       | 2,450                      |       |
| Total current  assets                                                                                                   |       | 64,953                       |       | 82,280                     |       |
|                                                                                                                    |       |                         |       |                       |       |
| PROPERTY AND  EQUIPMENT:                                                                                                |       |                         |       |                       |       |
| Computer and  office equipment                                                                                          |       | 3,608                        |       | 3,482                      |       |
| Leasehold  improvements                                                                                                 |       | 565                          |       | 608                        |       |
| Furniture and  fixtures                                                                                                 |       | 186                          |       | 189                        |       |
|                                                                                                                    |       | 4,359                        |       | 4,279                      |       |
| Less accumulated  depreciation and amortization                                                                         |       | (3,560                       | )          | (3,131                     | )          |
| Net property and  equipment                                                                                             |       | 799                          |       | 1,148                      |       |
|                                                                                                                    |       |                         |       |                       |       |
| OTHER ASSETS:                                                                                                           |       |                         |       |                       |       |
| Goodwill                                                                                                                |       | —                       |       | 1,166                      |       |
| Intangibles, net                                                                                                        |       | 6,090                        |       | 9,286                      |       |
| Other assets,  net                                                                                                      |       | 1,390                        |       | 1,072                      |       |
| Total other  assets                                                                                                     |       | 7,480                        |       | 11,524                     |       |
|                                                                                                                    |       |                         |       |                       |       |
| Total assets                                                                                                            |       | $                            | 73,232     |                       | $          | 94,952 |   |
|                                                                                                                    |       |                         |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                           | ** ** | ** **                   | ** ** | ** **                 | ** ** |
|                                                                                                                    |       |                         |       |                       |       |
| CURRENT  LIABILITIES:                                                                                                   |       |                         |       |                       |       |
| Accounts payable                                                                                                        |       | $                            | 1,825      |                       | $          | 1,978 |   |
| Payable to  BayStar II, LLP                                                                                             |       | 13,000                       |       | —                     |       |
| Royalty payable  to Novell, Inc.                                                                                   |       | 506                          |       | 2,025                      |       |
| Accrued  compensation to law firms                                                                                      |       | 7,956                        |       | 10,556                     |       |
| Accrued payroll  and benefits                                                                                           |       | 3,075                        |       | 4,752                      |       |
| Accrued  liabilities                                                                                                    |       | 10,749                       |       | 3,754                      |       |
| Derivative  related to redeemable convertible preferred stock                                                           |       | —                       |       | 15,224                     |       |
| Deferred revenue                                                                                                        |       | 5,936                        |       | 5,501                      |       |
| Other royalties  payable                                                                                                |       | 171                          |       | 523                        |       |
| Taxes payable                                                                                                           |       | 1,361                        |       | 799                        |       |
| Total current  liabilities                                                                                              |       | 44,579                       |       | 45,112                     |       |
|                                                                                                                    |       |                         |       |                       |       |
| LONG-TERM  LIABILITIES                                                                                                  |       | 501                          |       | 508                        |       |
|                                                                                                                    |       |                         |       |                       |       |
| MINORITY  INTEREST                                                                                                      |       | —                       |       | 145                        |       |
|                                                                                                                    |       |                         |       |                       |       |
| COMMITMENTS AND  CONTINGENCIES (Note 6)                                                                                 |       |                         |       |                       |       |
|                                                                                                                    |       |                         |       |                       |       |
| SERIES A  REDEEMABLE CONVERTIBLE PREFERRED STOCK, $0.001 par value, 0 and 50 shares  outstanding, respectively (Note 7) |       | —                       |       | 29,671                     |       |
|                                                                                                                    |       |                         |       |                       |       |
| COMMON STOCK  SUBJECT TO RESCISSION (Note 8)                                                                            |       | 557                          |       | —                     |       |
|                                                                                                                    |       |                         |       |                       |       |
| STOCKHOLDERS’  EQUITY:                                                                                             |       |                         |       |                       |       |
| Common stock,  $0.001 par value; 45,000 shares authorized, 17,750 and 13,824 shares  outstanding, respectively          |       | 18                           |       | 14                         |       |
| Additional  paid-in capital                                                                                             |       | 245,883                      |       | 218,690                    |       |
| Common stock  held in treasury                                                                                          |       | (2,414                       | )          | —                     |       |
| Warrants  outstanding                                                                                                   |       | 1,099                        |       | 1,099                      |       |
| Deferred  compensation                                                                                                  |       | (73                          | )          | (347                       | )          |
| Accumulated  other comprehensive income                                                                                 |       | 782                          |       | 926                        |       |
| Accumulated  deficit                                                                                                    |       | (217,700                     | )          | (200,866                   | )          |
| Total  stockholders’ equity                                                                                        |       | 27,595                       |       | 19,516                     |       |
|                                                                                                                    |       |                         |       |                       |       |
| Total  liabilities and stockholders’ equity                                                                        |       | $                            | 73,232     |                       | $          | 94,952 |   |

 

See notes tocondensed consolidated financial statements.

 

4

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)**

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

 
| ** **                                                                                                      | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| REVENUE:                                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| Products                                                                                                        |       | $                                    | 8,929      |                                | $          | 10,804 |   | $ | 27,056 |   | $ | 33,016 |   |
| SCOsource  licensing                                                                                            |       | 678                                  |       | 7,280                               |       | 709 |   | 15,530 |   |
| Services                                                                                                        |       | 1,598                                |       | 1,971                               |       | 4,969 |   | 6,418 |   |
| Total revenue                                                                                                   |       | 11,205                               |       | 20,055                              |       | 32,734 |   | 54,964 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| COST OF REVENUE:                                                                                                |       |                                 |       |                                |       |   |   |   |   |
| Products                                                                                                        |       | 741                                  |       | 1,200                               |       | 2,364 |   | 3,422 |   |
| SCOsource  licensing                                                                                            |       | 7,396                                |       | 1,796                               |       | 15,486 |   | 4,129 |   |
| Services                                                                                                        |       | 878                                  |       | 1,538                               |       | 3,273 |   | 5,008 |   |
| Total cost of  revenue                                                                                          |       | 9,015                                |       | 4,534                               |       | 21,123 |   | 12,559 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| GROSS MARGIN                                                                                                    |       | 2,190                                |       | 15,521                              |       | 11,611 |   | 42,405 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| OPERATING  EXPENSES:                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| Sales and  marketing (exclusive of stock-based compensation of $15, $31, $61 and $98,  respectively)            |       | 4,233                                |       | 5,930                               |       | 13,952 |   | 18,421 |   |
| Research and  development (exclusive of stock-based compensation of $12, $29, $36 and $82,  respectively)       |       | 2,592                                |       | 2,950                               |       | 8,167 |   | 8,142 |   |
| General and  administrative (exclusive of stock-based compensation of $243, $249, $771 and  $747, respectively) |       | 1,889                                |       | 1,413                               |       | 6,475 |   | 4,525 |   |
| Restructuring charges                                                                                           |       | —                               |       | 614                                 |       | — |   | 498 |   |
| Amortization of  intangibles                                                                                    |       | 593                                  |       | 895                                 |       | 1,973 |   | 2,295 |   |
| Loss on  impairment of long-lived assets                                                                        |       | —                               |       | —                              |       | 2,139 |   | — |   |
| Stock-based  compensation                                                                                       |       | 270                                  |       | 309                                 |       | 868 |   | 927 |   |
| Total operating  expenses                                                                                       |       | 9,577                                |       | 12,111                              |       | 33,574 |   | 34,808 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| INCOME (LOSS)  FROM OPERATIONS                                                                                  |       | (7,387                               | )          | 3,410                               |       | (21,963 | ) | 7,597 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| EQUITY IN INCOME  (LOSSES) OF AFFILIATES                                                                        |       | 41                                   |       | (71                                 | )          | 115 |   | (171 | ) |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| Interest income                                                                                                 |       | 186                                  |       | 42                                  |       | 698 |   | 92 |   |
| Change in fair  value of derivative (Note 7)                                                                    |       | —                               |       | —                              |       | 5,924 |   | — |   |
| Other expense,  net                                                                                             |       | (87                                  | )          | (97                                 | )          | (338 | ) | (151 | ) |
| Total other  income (expense), net                                                                              |       | 99                                   |       | (55                                 | )          | 6,284 |   | (59 | ) |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| INCOME (LOSS)  BEFORE INCOME TAXES                                                                              |       | (7,247                               | )          | 3,284                               |       | (15,564 | ) | 7,367 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| PROVISION FOR  INCOME TAXES                                                                                     |       | (176                                 | )          | (188                                | )          | (1,270 | ) | (495 | ) |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| NET INCOME  (LOSS)                                                                                              |       | (7,423                               | )          | 3,096                               |       | (16,834 | ) | 6,872 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| DIVIDENDS ON  REDEEMABLE CONVERTIBLE PREFERRED STOCK                                                            |       | 14,924                               |       | —                              |       | 7,123 |   | — |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| NET INCOME  (LOSS) APPLICABLE TO COMMON STOCKHOLDERS                                                            |       | $                                    | 7,501      |                                | $          | 3,096 |   | $ | (9,711 | ) | $ | 6,872 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| BASIC NET INCOME  (LOSS) PER COMMON SHARE                                                                       |       | $                                    | 0.49       |                                | $          | 0.25 |   | $ | (0.67 | ) | $ | 0.58 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| DILUTED NET  INCOME (LOSS) PER COMMON SHARE                                                                     |       | $                                    | 0.38       |                                | $          | 0.19 |   | $ | (0.67 | ) | $ | 0.47 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| WEIGHTED AVERAGE  BASIC COMMON SHARES OUTSTANDING                                                               |       | 15,242                               |       | 12,469                              |       | 14,389 |   | 11,753 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| WEIGHTED AVERAGE  DILUTED COMMON SHARES OUTSTANDING                                                             |       | 19,912                               |       | 16,180                              |       | 14,389 |   | 14,744 |   |
|                                                                                                            |       |                                 |       |                                |       |   |   |   |   |
| OTHER  COMPREHENSIVE INCOME (LOSS):                                                                             |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss)                                                                                              |       | $                                    | (7,423     | )                                   | $          | 3,096 |   | $ | (16,834 | ) | $ | 6,872 |   |
| Unrealized loss  on available-for-sale securities                                                               |       | (42                                  | )          | —                              |       | (160 | ) | — |   |
| Foreign currency  translation adjustment                                                                        |       | (132                                 | )          | 204                                 |       | 16 |   | 430 |   |
| COMPREHENSIVE  INCOME (LOSS)                                                                                    |       | $                                    | (7,597     | )                                   | $          | 3,300 |   | $ | (16,978 | ) | $ | 7,302 |   |

 

See notes tocondensed consolidated financial statements.

 

5

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

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited, in thousands)**

 
| ** **                                                                                           | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                           | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                                                           | ** ** | **(Restated -  see Note 2)**        | ** ** | ** ** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                               |       |                                |       |   |   |
| Net income  (loss)                                                                                   |       | $                                   | (16,834    | ) | $ | 6,872 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                |       |   |   |
| Change in fair  value of derivative                                                                  |       | (5,924                              | )          | — |   |
| Loss on  impairment of long-lived assets                                                             |       | 2,139                               |       | — |   |
| Amortization of  intangibles (including $250 and $253 classified as cost of revenue)                 |       | 2,223                               |       | 2,548 |   |
| Depreciation and  other amortization                                                                 |       | 629                                 |       | 815 |   |
| Stock-based  compensation                                                                            |       | 868                                 |       | 927 |   |
| Equity in  (income) losses of affiliates                                                             |       | (115                                | )          | 171 |   |
| Issuance of a  warrant included as cost of SCOsource licensing revenue                               |       | —                              |       | 94 |   |
| Changes in  operating assets and liabilities                                                         |       |                                |       |   |   |
| Accounts  receivable, net                                                                            |       | 3,328                               |       | 1,047 |   |
| Other current  assets                                                                                |       | (16                                 | )          | 854 |   |
| Other assets                                                                                         |       | (204                                | )          | 1,140 |   |
| Accounts payable                                                                                     |       | (153                                | )          | (407 | ) |
| Accrued payroll  and benefits                                                                        |       | (1,677                              | )          | (325 | ) |
| Accrued  compensation to law firms                                                                   |       | (2,600                              | )          | — |   |
| Accrued  liabilities                                                                                 |       | 6,995                               |       | (2,286 | ) |
| Deferred revenue                                                                                     |       | 435                                 |       | (3,234 | ) |
| Other royalties  payable                                                                             |       | (352                                | )          | (1 | ) |
| Taxes payable                                                                                        |       | 562                                 |       | 137 |   |
| Long-term  liabilities                                                                               |       | (7                                  | )          | (1,576 | ) |
| Net cash  provided by (used in) operating activities                                                 |       | (10,703                             | )          | 6,776 |   |
|                                                                                                 |       |                                |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                               |       |                                |       |   |   |
| Purchase of  property and equipment                                                                  |       | (331                                | )          | (524 | ) |
| Purchase of  available-for-sale securities                                                           |       | (53,520                             | )          | — |   |
| Proceeds from  available-for-sale securities                                                         |       | 20,010                              |       | — |   |
| Purchase of  minority interest in Japanese subsidiary                                                |       | (209                                | )          | — |   |
| Investment in  non-marketable securities                                                             |       | —                              |       | (950 | ) |
| Net cash used in  investing activities                                                               |       | (34,050                             | )          | (1,474 | ) |
|                                                                                                 |       |                                |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                               |       |                                |       |   |   |
| Proceeds from  sale of common stock through ESPP                                                     |       | 810                                 |       | 236 |   |
| 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 proceeds  from the issuance of a warrant                                                         |       | —                              |       | 650 |   |
| Proceeds from  exercise of common stock options                                                      |       | 591                                 |       | 1,443 |   |
| Net cash  provided by (used in) financing activities                                                 |       | (14,224                             | )          | 2,329 |   |
|                                                                                                 |       |                                |       |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                                |       | (58,977                             | )          | 7,631 |   |
| EFFECT OF  FOREIGN EXCHANGE RATES ON CASH                                                            |       | 131                                 |       | 441 |   |
| CASH AND CASH  EQUIVALENTS, beginning of period                                                      |       | 64,428                              |       | 6,589 |   |
| CASH AND CASH  EQUIVALENTS, end of period                                                            |       | $                                   | 5,582      |   | $ | 14,661 |   |
|                                                                                                 |       |                                |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                                   |       |                                |       |   |   |
|                                                                                                 |       |                                |       |   |   |
| Cash paid for  taxes                                                                                 |       | $                                   | 652        |   | $ | 297 |   |
|                                                                                                 |       |                                |       |   |   |
| SUPPLEMENTAL  SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:                           |       |                                |       |   |   |
|                                                                                                 |       |                                |       |   |   |
| Accretion of  dividends                                                                              |       | $                                   | 2,047      |   | $ | — |   |
|                                                                                                 |       |                                |       |   |   |
| Capital  contribution in connection with repurchase and cancellation of Series A-1  shares      |       | $                                   | (15,475    | ) | $ | — |   |
|                                                                                                 |       |                                |       |   |   |
| Dividend in  connection with exchange of Series A-1 for Series A                           |       | $                                   | 6,305      |   | $ | — |   |
|                                                                                                 |       |                                |       |   |   |
| Acquisition of  Vultus, Inc.:                                                                   |       |                                |       |   |   |
| Common stock  issued                                                                                 |       | $                                   | —     |   | $ | 2,461 |   |
| Accrued  liabilties assumed                                                                          |       | $                                   | —     |   | $ | 215 |   |
|                                                                                                 |       |                                |       |   |   |
| Common stock  subject to rescission                                                                  |       | $                                   | 557        |   | $ | — |   |

 

See notes tocondensed consolidated financial statements.

 

6

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

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

 

The business of The SCO Group, Inc. (the “Company”) focuses onmarketing reliable, cost-effective UNIX software products and related servicesfor the small-to-medium sized business market. In January 2003, the Company established its SCOsource business andlaunched its first of several SCOsource initiatives to review and enforce itsintellectual property surrounding the UNIX operating system. The Companyacquired certain intellectual property rights surrounding UNIX and UNIX System Vsource code from The Santa Cruz Operation (now Tarantella, Inc.) in May 2001.

 

**(2) RESTATEMENT OF FINANCIALSTATEMENTS**

 

The Company’s previouslyissued condensed consolidated financial statements as of and for the three andnine months ended July 31, 2004 have been restated to reclassify frompermanent equity to temporary equity $557,000 related to certain shares ofcommon stock issued under the Company’s equity compensation plans that aresubject to rescission because were issued without appropriate registrationunder applicable securities laws.  As aresult, certain plan participants have a right to rescind their purchase ofshares or recover damages if they no longer own the shares.  Holders of such shares have a rescissionright against the Company and the exercise of such rescission right may dependin part on the price of the Company’s common stock which is outside both theCompany’s and the holders’ control.  Thereclassification amount of $557,000 in the aggregate, excluding interest andother possible fees was based upon shares outstanding as of July 31, 2004.

 

In addition to the aboverestatement, the Company has made a reclassification of $10,400,000 from cashand cash equivalents to available-for-sale securities to reflect theappropriate classification of certain auction rate securities as the originalmaturity of these securities is greater than three months.

 

The following tablesummarizes the effect of the restatement and reclassification adjustments onthe Financial Statements as of and for the nine months ended July 31, 2004(in thousands):

 
| ** **                          | ** ** | **As of July 31,**    | ** ** |
|-------------------------------------|------------|----------------------------|------------|
| ** **                          | ** ** | **2004**                   | ** ** | **2004** | ** ** |
| ** **                          | ** ** | **(Previously  Reported)** | ** ** | **(Restated)** | ** ** |
| Cash and  equivalents               |       | $                          | 15,982     |   | $ | 5,582 |   |
| Available-for-sale  securities      |       | 27,045                     |       | 37,445 |   |
| Common stock  subject to rescission |       | —                     |       | 557 |   |
| Additional  paid-in capital         |       | 246,440                    |       | 245,883 |   |
| Total  stockholders’ equity    |       | 28,152                     |       | 27,595 |   |
|                                     |            |                            |            |  |  |  |  |

 
| ** **                             | ** ** | **Nine Months Ended July 31,** | ** ** |
|----------------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **2004**                       | ** ** | **2004** | ** ** |
| ** **                             | ** ** | **(Previously  Reported)**     | ** ** | **(Restated)** | ** ** |
| Net cash used in  investing activities |       | (23,650                        | )          | (34,050 | )  |

 

The Company’s previouslyissued notes to condensed consolidated financial statements for the three andnine months ended July 31, 2004 have been restated to correct theaccounting for the following item:

 

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•                  Restatingthe pro forma fair value of stock-based compensation in the notes to condensedconsolidated financial statements for the three and nine months ended July 31,2004 by $219,000 and $573,000, respectively, to appropriately include the fairvalue of certain equity awards that were not correctly included in the originaldisclosure.

 

The following tablesummarizes the effect of this restatement adjustment on the notes to condensedconsolidated financial statements for the three and nine months ended July 31,2004 (in thousands, except per share amounts):

 
| ** **                                                             | ** ** | **Three Months Ended July 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                             | ** ** | **2004**                             | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | **(Previously  Reported)**           | ** ** | **(Restated)** | ** ** |
| Net income  available to common stockholders:                          |       |                                 |       |   |   |
| As reported                                                            |       | $                                    | 7,501      |   | $ | 7,501 |   |
| Stock-based  compensation as reported                                  |       | 270                                  |       | 270 |   |
| Stock-based  compensation under fair value method                      |       | (197                                 | )          | (416 | ) |
| Pro forma net  income                                                  |       | $                                    | 7,574      |   | $ | 7,355 |   |
|                                                                   |       |                                 |       |   |   |
| Net income  available to common stockholders per diluted common share: |       |                                 |       |   |   |
| As reported                                                            |       | $                                    | 0.38       |   | $ | 0.38 |   |
| Pro forma                                                              |       | $                                    | 0.38       |   | $ | 0.37 |   |

 
| ** **                                                            | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                            | ** ** | **2004**                            | ** ** | **2004** | ** ** |
| ** **                                                            | ** ** | **(Previously  Reported)**          | ** ** | **(Restated)** | ** ** |
| Net loss  applicable to common stockholders:                          |       |                                |       |   |   |
| As reported                                                           |       | $                                   | (9,711     | ) | $ | (9,711 | ) |
| Stock-based  compensation as reported                                 |       | 868                                 |       | 868 |   |
| Stock-based compensation  under fair value method                     |       | (1,126                              | )          | (1,699 | ) |
| Pro forma net  loss                                                   |       | $                                   | (9,969     | ) | $ | (10,542 | ) |
|                                                                  |       |                                |       |   |   |
| Net loss  applicable to common stockholders per diluted common share: |       |                                |       |   |   |
| As reported                                                           |       | $                                   | (0.67      | ) | $ | (0.67 | ) |
| Pro forma                                                             |       | $                                   | (0.69      | ) | $ | (0.73 | ) |

 

## **(3) SIGNIFICANT ACCOUNTINGPOLICIES**

 

### **Basis of Presentation**

 

The accompanying unaudited condensed consolidatedfinancial statements of the Company have been prepared by the Company pursuantto the rules and regulations of the Securities and Exchange Commission (“SEC”)on a basis consistent with the Company’s audited annual financial statementsand, in the opinion of management, reflect all adjustments, consisting ofnormal recurring adjustments, necessary to present fairly the financialinformation set forth therein.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of

 

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America have beencondensed or omitted pursuant to SEC rules and regulations, although theCompany believes that the following disclosures, when read in conjunction withthe audited annual financial statements and the notes thereto included in theCompany’s most recent annual report on Form 10-K, are adequate to make theinformation presented not misleading. Operating results for the three and nine months ended July 31, 2004are not necessarily indicative of the results that may be expected for the yearending October 31, 2004.

 

### **Use of Estimates in the Preparation of FinancialStatements**

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period.  Actual results could differ from theseestimates.  The Company’s criticalaccounting policies and estimates include, among others, revenue recognition,allowances for doubtful accounts receivable, determination of fair value of thederivative previously associated with the Company’s retired Series AConvertible Preferred Stock and fair value of the Company’s retired Series A-1Convertible Preferred Stock, impairment of long-lived assets, and valuationallowances against deferred income tax assets.

 

### **Revenue Recognition**

 

The Company recognizes revenue in accordance withStatement of Position (“SOP”) 97-2, as modified by SOP 98-9, and StaffAccounting Bulletin (“SAB”) No. 104. Revenue recognition in accordance with these pronouncements can becomplex due to the nature and variability of the Company’s salestransactions.  The Company’s revenue isprimarily from three sources: (i) product license revenue, primarily fromproduct sales distributors and end users, and royalty revenue from productsales to original equipment manufacturers (“OEMs”); (ii) service andsupport revenue, primarily from providing support, education and consultingservices to end users; and (iii) licensing revenue from its SCOsourceintellectual property initiative.

 

The Company recognizes product revenue upon shipmentif a signed contract exists, the fee is fixed and determinable, collection ofthe resulting receivable is probable and product returns are reasonablyestimable, except for sales to distributors, which are recognized upon sale bythe distributor to end users.

 

The majority of the Company’s revenue transactionsrelate to product-only sales.  Onoccasion, the Company has revenue transactions that have multiple elements(such as delivered and undelivered products, maintenance and other services).  For software agreements that have multipleelements, the Company allocates revenue to each component of the contract basedon the relative fair value of the elements. The fair value of each element is based on vendor specific objectiveevidence (“VSOE”).  VSOE is establishedwhen such elements are sold separately. The Company recognizes revenue allocated to undelivered products whenthe criteria for product revenue recognition set forth above have been met.  If VSOE of all undelivered elements exists,but VSOE does not exist for one or more delivered elements, then revenue isrecognized using the residual method. Under the residual method, the fair value of the undelivered elements isdeferred and recognized in future periods and the remaining portion of thelicense fee is recognized in the current period as product revenue.

 

9

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The Company recognizes product revenue from OEM’s uponreceipt of sales-out royalty reports and recognizes revenue for ongoingcustomer support ratably over the period of the contract.  Payments for fees are generally made inadvance and are non-refundable.  Revenuefrom consulting services is recognized as the related services are performed.

 

The Company’s SCOsource licensing revenue to date hasbeen primarily generated from license agreements to utilize the Company’s UNIXsource code as well as from intellectual property compliance licenses.  The Company recognizes revenue from SCOsourcelicensing agreements when a signed contract exists, the fee is fixed anddeterminable, collection of the receivable is probable and delivery hasoccurred.  If the payment terms extendbeyond the Company’s normal payment terms, revenue is recognized as thepayments become due.

 

**Pro FormaFair Value of Stock-based Compensation**

 

The Company accounts for stock options issued todirectors, officers and employees under Accounting Principles Board (“APB”) No. 25.  Under APB No. 25, compensation expenseis recognized if an option’s exercise price on the measurement date is belowthe fair market value of the Company’s common stock.

 

Statements of Financial Accounting Standards (“SFAS”) No. 148,“Accounting for Stock-Based Compensation,” requires pro forma informationregarding net income(loss) to common stockholders as if the Company had accounted for its stockoptions granted under the fair value method. The fair value for the Company’s stock options is estimated on the dateof grant using the Black-Scholes option-pricing model.

 

With respect to stockoptions, restricted stock awards granted and employee stock purchase program (“ESPP”)shares purchased during the three and nine months ended July 31, 2004 and2003, the assumptions used are listed in the following table: 

 
| ** **                | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Risk-free  interest rate  |       | 3.1                                  | %          | 3.4                                 | %          | 2.8 | % | 3.4 | % |
| Expected  dividend yield  |       | 0.0                                  | %          | 0.0                                 | %          | 0.0 | % | 0.0 | % |
| Volatility                |       | 87.6                                 | %          | 157                                 | %          | 84.2 | % | 132 | % |
| Expected life  (in years) |       | 2.9                                  |       | 2.6                                 |       | 3.0 |   | 2.6 |   |

 

10

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For purposes of the pro formadisclosure, the estimated fair value of the stock options, restricted stockawards and ESPP shares are amortized over the vesting period of the award.  The following is the pro forma disclosure andthe related impact on net income (loss) and the net income (loss) per dilutedcommon share for the three and nine months ended July 31, 2004 and 2003(in thousands, except per share amounts):

 
| ** **                                                                     | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                     | ** ** | **(restated)**                       | ** ** | ** **                          | ** ** | **(restated)** | ** ** | ** ** | ** ** |
| Net income  (loss) applicable to common stockholders:                          |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                    |       | $                                    | 7,501      |                                | $          | 3,096 |   | $ | (9,711 | ) | $ | 6,872 |   |
| Stock-based  compensation as reported                                          |       | 270                                  |       | 309                                 |       | 868 |   | 927 |   |
| Stock-based  compensation under fair value method                              |       | (416                                 | )          | (507                                | )          | (1,699 | ) | (1,446 | ) |
| Pro forma net  income (loss)                                                   |       | $                                    | 7,355      |                                | $          | 2,898 |   | $ | (10,542 | ) | $ | 6,353 |   |
|                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss) applicable to common stockholders per diluted common share: |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                    |       | $                                    | 0.38       |                                | $          | 0.19 |   | $ | (0.67 | ) | $ | 0.47 |   |
| Pro forma                                                                      |       | $                                    | 0.37       |                                | $          | 0.18 |   | $ | (0.73 | ) | $ | 0.43 |   |

 

**Cash and Cash Equivalents and Available-for-Sale Securities**

 

The Company considers all highly liquid debtinstruments purchased with original maturities of three or fewer months to becash equivalents.  Cash equivalents were$2,165,000 as of July 31, 2004 and $61,701,000 as of October 31,2003, which primarily consisted of investments in money market funds,commercial paper, corporate notes and agencies.

 

Available-for-salesecurities consist primarily of securities that either mature within the next12 months or have characteristics of short-term investments.  All available-for-sale securities areavailable for working capital purposes as necessary.  Available-for-sale securities are recorded atfair market value based on quoted market prices and any unrealized gains andlosses are included as a component of other comprehensive income untilrealized.  Any declines in market valuethat are considered to be other than temporary are charged to earnings.

 

**NetIncome (Loss) per Common 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 netincome (loss) per common share (“Diluted EPS”) is computed by dividing netincome (loss) by the sum of the weighted average number of common sharesoutstanding and the dilutive potential common share equivalents thenoutstanding.  Potential common shareequivalents consist of the weighted average of shares issuable upon theexercise of outstanding stock options, restricted stock awards, warrants toacquire common stock and preferred stock convertible into common shares.   The excluded anti-dilutive common shareequivalents are not included in the computation of Diluted EPS as their effectwould have decreased Diluted EPS.

 

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The following table is a reconciliation of thenumerator and denominator of Basic EPS to the numerator and denominator ofDiluted EPS (in thousands, except per share amounts):

 
| ** **                                                             | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                             | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                   |       |                                 |       |                                |       |   |   |   |   |
| Numerator:                                                             |       |                                 |       |                                |       |   |   |   |   |
| Basic and  diluted net income (loss) applicable to common stockholders |       | $                                    | 7,501      |                                | $          | 3,096 |   | $ | (9,711 | ) | $ | 6,872 |   |
|                                                                   |       |                                 |       |                                |       |   |   |   |   |
| Denominator:                                                           |       |                                 |       |                                |       |   |   |   |   |
| Weighted average  common basic shares outstanding                      |       | 15,242                               |       | 12,469                              |       | 14,389 |   | 11,753 |   |
| Effect of  convertible preferred stock                                 |       | 2,657                                |       | —                              |       | — |   | — |   |
| Effect of stock  options                                               |       | 1,740                                |       | 3,032                               |       | — |   | 2,485 |   |
| Effect of  restricted stock awards                                     |       | 125                                  |       | 515                                 |       | — |   | 433 |   |
| Effect of  warrants                                                    |       | 148                                  |       | 164                                 |       | — |   | 73 |   |
| Weighted average  common diluted shares outstanding                    |       | 19,912                               |       | 16,180                              |       | 14,389 |   | 14,744 |   |
|                                                                   |       |                                 |       |                                |       |   |   |   |   |
| Basic EPS                                                              |       | $                                    | 0.49       |                                | $          | 0.25 |   | $ | (0.67 | ) | $ | 0.58 |   |
| Diluted EPS                                                            |       | $                                    | 0.38       |                                | $          | 0.19 |   | $ | (0.67 | ) | $ | 0.47 |   |
|                                                                   |       |                                 |       |                                |       |   |   |   |   |
| Excluded  anti-dilutive common share equivalents                       |       | 998                                  |       | 212                                 |       | 397 |   | 360 |   |

 

**Reclassifications**

 

Certain reclassifications have been made to the priorperiod amounts to conform to the current period presentation.  The reclassifications had no effect on netincome for the prior periods.

 

**(4) GOODWILL AND INTANGIBLE ASSETS**

 

The following table shows the activity related toamortized intangible assets for the nine months ended July 31, 2004 andremaining unamortized balances as of July 31, 2004 (in thousands):

 
| ** **                      | ** ** | **As of**                 | ** ** | **Nine Months Ended  July 31, 2004** | ** ** | **As of**      | ** ** |
|---------------------------------|------------|---------------------------|------------|-------------------------------------------|------------|----------------|------------|
| ** **                      | ** ** | **October 31, 2003** | ** ** | **Amortization**                          | ** ** | **Impairment** | ** ** | **July 31, 2004** | ** ** |
| ** **                      | ** ** | **Net Book Value**        | ** ** | **Expense**                               | ** ** | **Loss**       | ** ** | **Net Book Value** | ** ** |
| Amortizable  intangible assets: |       |                      |       |                                      |       |           |       |   |   |
| Distribution/reseller  channel  |       | $                         | 6,954      |                                      | $          | 1,739          |       | $ | — |   | $ | 5,215 |   |
| Acquired  technology            |       | 1,009                     |       | 252                                       |       | —         |       | 757 |   |
| Acquired  technology            |       | 1,166                     |       | 193                                       |       | 973            |       | — |   |
| Trade name                      |       | 157                       |       | 39                                        |       | —         |       | 118 |   |
| Total intangible  assets        |       | $                         | 9,286      |                                      | $          | 2,223          |       | $ | 973 |   | $ | 6,090 |   |

 

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Of the $2,223,000 in amortization expense, $250,000was classified as amortization of intangible assets in operating expenses andthe remaining $1,973,000 was classified as cost of products revenue.

 

The Company recorded a loss on impairment oflong-lived assets totaling $2,139,000, which related to an impairment onintangible assets of $973,000 and an impairment of goodwill of $1,166,000 forthe nine months ended July 31, 2004. The impairment related to goodwill and intangible assets acquired inconnection with the acquisition of Vultus, Inc. (“Vultus”) in June 2003.  The Company concluded that animpairment-triggering event occurred during the three months ended April 30,2004 as an impending partnership that would solidify the Vultus revenue andcash flow opportunities did not materialize. Additionally, the Company had a reduction in force that impacted theCompany’s ability to move the Vultus initiative forward on a stand-alonebasis.  Consequently, the Company hasconcluded that no significant future cash flows related to its Vultus assetswould be realized.  The Company performedan impairment analysis of its recorded goodwill related to the Vultus reportingunit in accordance with SFAS No. 142. Additionally, an impairment analysis of the intangible assets wasperformed in accordance with SFAS No. 144. As a result of these analyses, the Company wrote-down the carrying valueof its goodwill related to the Vultus acquisition from $1,166,000 to $0 andwrote-down intangible assets related to its Vultus acquisition from $973,000 to$0.

 

**(5) RESTRUCTURINGPLANS**

 

The Company’s board of directors and management hasadopted restructuring plans to reduce facilities and personnel.  These restructuring plans resulted in theCompany recording expense and accruals for the costs associated with thereduction in facilities and for severance costs of affected employees.

 

During the three monthsended April 30, 2004, in connection with management’s plan to reduceoperating expenses, the Company announced a plan which resulted in a charge of$682,000 that has been included in general and administrative expense.  The plan principally included the eliminationof approximately 16 percent of the Company’s workforce.  It impacted all operating departments andclosed one small facility.

 

The following table summarizes the activity related tothe Company’s restructuring accruals as of July 31, 2004 (in thousands):

 
| ** ** | ** ** | **Balance as of  October 31,  2003** | ** ** | **Additions** | ** ** | **Payments** | ** ** | **Balance as of  July 31,  2004** | ** ** |
|------------|------------|-------------------------------------------|------------|---------------|------------|--------------|------------|----------------------------------------|------------|
|       |       |                                      |       |          |       |         |       |                                   |       |
| Facilities |       | $                                         | 348        |          | $          | 39           |       | $                                      | (196       | ) | $ | 191 |   |
| Employees  |       | —                                    |       | 643           |       | (643         | )          | —                                 |       |
| Total      |       | $                                         | 348        |          | $          | 682          |       | $                                      | (839       | ) | $ | 191 |   |

 

The remaining restructuring accrual at July 31,2004 relates to costs associated with one facility that has future leasepayments extending through June 2005.

 

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**(6) COMMITMENTSAND CONTINGENCIES**

 

**Litigation**

 

*IBM Corporation*

 

On or about March 6, 2003, the Company filed acomplaint against IBM Corporation (“IBM”). The action is currently pending in the United States District Court forthe District of Utah.  The initialcomplaint included claims for breach of contract, misappropriation of tradesecrets, tortious interference, and unfair competition.  The initial complaint also alleged that IBMobtained information concerning the UNIX source code and derivative works fromthe Company and inappropriately used and distributed that information inconnection with its efforts to promote the Linux operating system.  As a result of IBM’s actions, the Company isrequesting damages in an amount to be proven at trial, together with additionaldamages through and after the time of trial. Additionally, on or about June 13, 2003, the Company delivered toIBM a notice of termination of IBM’s UNIX license agreement with the Company,which license underlies IBM’s AIX software.

 

On or about June 16,2003, the Company filed an amended complaint in the IBM case.  The amended complaint essentially restatedand re-alleged the allegations of the initial complaint and expanded on thoseclaims.  Most importantly, the amendedcomplaint raised new allegations regarding IBM’s actions and breaches throughthe actions of Sequent Computer Systems, Inc. (“Sequent”), which IBMacquired.  The Company alleged itslicense agreement with Sequent was breached in several ways similar to thoseset forth above and it seeks damages for those breaches.  The Company also seeks injunctive relief onseveral of its claims.

 

IBM filed a response and counterclaim to thecomplaint, including a demand for a jury trial. The Company has filed an answer to the IBM counterclaim denying theclaims and asserting affirmative defenses. On February 4, 2004, the Company filed a motion for leave to fileamended pleadings in the case proposing to amend its complaint against IBM andto modify its affirmative defenses against IBM’s counterclaims.  On February 25, 2004, the court grantedthe Company’s motion for leave to amend. The second amended complaint, which was filed on February 27, 2004,alleges nine causes of action that are similar to those set forth above, adds anew claim for copyright infringement and removes the claim for misappropriationof trade secrets.  IBM has filed ananswer and counterclaim.  Thecounterclaim filed by IBM asserts 14 claims against the Company.  In its counterclaim, as amended, IBM assertsthat the Company does not have the right to terminate IBM’s UNIX license orassert claims based on the Company’s ownership of UNIX intellectual propertyagainst IBM or others in the Linux community. In addition, IBM asserts that the Company has breached the GNU GeneralPublic License and has infringed certain patents held by IBM.  IBM’s counterclaims include claims for breachof contract, violation of the Lanham Act, unfair competition, intentionalinterference with prospective economic relations, unfair and deceptive tradepractices, promissoryestoppel, copyright infringement for a declaratory judgment of non-infringementof copyrights, and patent infringement.

 

On March 3, 2004, the U.S. MagistrateJudge issued an order addressing certain discovery matters relating to both theCompany and IBM.  The Company filed amotion to dismiss IBM’s tenth counterclaim for a declaratory judgment ofnon-infringement of copyrights.  TheCompany has also filed a motion to amend the scheduling order and a motion tobifurcate IBM’s patent

 

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counterclaimsinto another action.  The Company filed,on May 28, 2004, a reply brief in connection with its motion to amend thescheduling order, in which the Company sets forth detailed and specificresponses to IBM’s claims made in connection with that motion.  A hearing for these motions was held on June 8,2004, and the court issued its ruling on June 10, 2004.

 

The court granted the Company’s motion toamend the scheduling order, with certain changes.  The amended scheduling order now provides,among other things, that the deadline for completing fact discovery is February 11,2005 (previously August 4, 2004), the deadline for completing expertdiscovery is April 22, 2005 (previously October 22, 2004), and thetrial will begin on November 1, 2005 (previously April 11,2005).  The court also denied the Company’smotion to bifurcate IBM’s patent counterclaims without prejudice to the Company’sright to request a bifurcation again at a later date.  IBM has also filed a motion for partialsummary judgment on its tenth counterclaim for a declaration ofnon-infringement of the Company’s copyrights. A hearing regarding the Company’s motion to dismiss and IBM’s motion forpartial summary judgment on IBM’s tenth counterclaim for a declaration ofnon-infringement is currently scheduled for September 15, 2004.  The Company plans to vigorously oppose IBM’smotion.  The Company has filed variousmotions seeking additional discovery from IBM. IBM has filed two additional motions for summary judgment which theCompany will vigorously oppose.  Inaddition to the materials that have been publicly filed with the court, certaininformation has been filed under seal in accordance with the protective orderentered in the case.

 

*Red Hat, Inc.*

 

On or about August 4, 2003, Red Hat, Inc. (“RedHat”) filed a complaint against the Company in the United States District Courtfor the District of Delaware.  Red Hatasserts that the Linux operating system does not infringe on the Company’s UNIXintellectual property rights and seeks a declaratory judgment for non-infringementof copyrights and no misappropriation of trade secrets.  In addition, Red Hat claims the Company hasengaged in false advertising in violation of the Lanham Act, deceptive tradepractices, unfair competition, tortious interference with prospective businessopportunities, trade libel and disparagement.

 

On or about September 15, 2003, the Company fileda motion to dismiss the Red Hat complaint. The motion to dismiss asserts that Red Hat lacks standing and that nocase or controversy exists with respect to the claims seeking a declaratoryjudgment of non-infringement.  The motionto dismiss further asserts that Red Hat’s claims under the Lanham Act andrelated state laws are barred by the First Amendment to the U.S. Constitutionand the common law privilege of judicial immunity.  On April 6, 2004, the court issued anorder denying the Company’s motion to dismiss; however, the court stayed thecase and requested status reports every 90 days regarding the case againstIBM.  Red Hat has filed a motion forreconsideration.  The Company intends tocontinue to vigorously defend this action.

 

*Novell, Inc.*

 

On or about January 20, 2004, the Companybrought suit in Utah state court against Novell, Inc. (“Novell”) forslander of title seeking relief for Novell’s alleged bad faith efforts tointerfere with the Company’s ownership of copyrights related to its UNIX sourcecode and derivative works and its UnixWare product.  In the lawsuit, the Company requestedpreliminary and permanent injunctive relief as well as damages.  Through these claims, the Company seeks torequire Novell to assign to the Company all copyrights that it believes Novellhas wrongfully

 

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registered, preventNovell from representing any ownership interest in those copyrights and requireNovell to retract or withdraw all representations it has made regarding itspurported ownership of those copyrights. Novell also filed a motion to dismiss the Company’s complaint claimingit never transferred the copyrights to The Santa Cruz Operation (now Tarantella, Inc.).  The Company filed a response to Novell’smotion to dismiss and also filed a motion to remand the case back to the statecourt.  On June 10, 2004, the courtissued a memorandum decision and order which denied the Company’s motion toremand the case to state court.  Thememorandum decision also denied Novell’s motion to dismiss in part on claims offalsity.  However, the court grantedNovell’s motion to dismiss regarding the Company’s allegations of specialdamages, but granted the Company 30 days leave to amend its complaint to pleadspecial damages with more specificity. The Company has filed its amended complaint and Novell has respondedwith another motion to dismiss claiming that Novell’s alleged slanderousstatements are privileged under the law. The Company plans to continue to vigorously pursue its claims againstNovell.

 

*DaimlerChryslerCorporation*

 

On or around March 3, 2004, the Company broughtsuit against DaimlerChrysler Corporation (“DaimlerChrysler”) for its allegedviolations of its UNIX software agreement with the Company.  Specifically, the lawsuit alleges thatDaimlerChrysler breached its UNIX software agreement with the Company byfailing to certify by January 31, 2004 its compliance with the UNIXsoftware agreement as required by the Company. The lawsuit, filed in Oakland County Circuit Court in the State ofMichigan, requests the court to declare that DaimlerChrysler has violated thecertification requirements of its UNIX software agreement, permanently enjoinDaimlerChrysler from further violations of the UNIX software agreement, issue amandatory injunction requiring DaimlerChrysler to remedy the effects of itspast violations of the UNIX software agreement and award the Company damages inan amount to be determined at trial together with costs, attorneys’ fees andany such other or different relief that the Court may deem to be equitable andjust.  On April 15, 2004,DaimlerChrysler filed a motion to dismiss the Company’s claims.  DaimlerChrysler’s motion was heard on July 21,2004 and the court granted DaimlerChrysler’s motion as to the substance ofDaimlerChrysler’s certification, but denied the motion as to whether thecertification was timely.  The Company iscurrently evaluating this matter and any further actions it may take.

 

*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.  Specifically, the lawsuit alleges thatAutoZone is infringing the Company’s UNIX copyrights by, among other things,running versions of the Linux operating system that contain code, structure,sequence and/or organization from the Company’s proprietary UNIX System V codein violation of its copyrights.  Thelawsuit filed in U.S. District Court in Nevada requests injunctive reliefagainst AutoZone’s further use or copying of any part of the Company’scopyrighted materials and also requests damages as a result of AutoZone’sinfringement in an amount to be proven at trial.  On April 23, 2004, AutoZone filed amotion to transfer the case to Tennessee or to stay the case.  On August 6, 2004, the federal court inNevada entered an order granting AutoZone’s motion to stay the case with 90-daystatus reports to the court.  The courtdenied without prejudice AutoZone’s motion for a more definite statement andits motion to transfer the case to Tennessee. The court also is allowing the parties to take limited expediteddiscovery relating to the issue of preliminary injunctive relief requested bythe Company.  The Company is undertakingthat discovery process.

 

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*IPO Class ActionMatter*

 

The Company is an issuer defendant in a series ofclass action lawsuits involving over 300 issuers that have been consolidatedunder one action.  The consolidatedcomplaint alleges among other things, certain improprieties regarding theunderwriters’ conduct during the Company’s initial public offering and thefailure to disclose such conduct in the registration statement in violation ofthe Securities Act of 1933, as amended.

 

The plaintiffs, the issuers and the insurancecompanies have negotiated an agreement to settle the dispute between theplaintiffs and the issuers.  All parties,including the plaintiffs, issuers and insurance companies, have executed thissettlement agreement and the settlement agreement has been submitted to thecourt for approval.  If the settlementagreement is approved by the court, and if no cross-claims, counterclaims orthird party claims are later asserted, this action will be dismissed withrespect to the Company and its directors.

 

The Company has notified its underwriters andinsurance companies of the existence of the claims.  Management believes, after consultation withlegal counsel, that the ultimate outcome of this matter will not have amaterial adverse effect on the Company’s results of operations or financialposition.  As of July 31, 2004, theCompany has paid or accrued the full retention amount of $200,000under its insurance coverage.

 

*Other Matters*

 

In April 2003, a former Indian distributor of theCompany filed a claim in India, requesting summary judgment for payment of$1,428,000, and an order that the Company trade in India only through thedistributor and/or to give a security deposit until the claim is paid.  The distributor claims that the Company isresponsible to repurchase certain software products and to reimburse thedistributor for certain other operating costs. Management does not believe that the Company is responsible to reimbursethe distributor for any operating costs and also believes that the returnrights related to any remaining inventory have lapsed.  Management has engaged local counsel who hasadvised it that such claims will likely fail, but that the distributor willcontinue to pursue its claims either in the Indian courts or in the U.S.courts.  Discovery has commenced andhearings have been held and are ongoing. The Company intends to vigorously defend this action.

 

Pursuit and defense of the above-mentioned matterswill be costly, and management expects the costs for legal fees and relatedexpenses may be substantial.  Theultimate outcome or potential effect on the Company’s results of operations orfinancial position of the above-mentioned matters is not currently known ordeterminable.

 

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

 

**Arrangement with Law Firms**

 

On or about February 26, 2003, the Companyentered into an arrangement with Boies, Schiller & Flexner LLP andother firms to investigate and review the Company’s UNIX

 

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intellectual propertyrights.  This arrangement was latermodified on November 17, 2003 and December 8, 2003.  The engagement with the law firms nowincludes the defense work related to counter suits and other retaliatoryactions against the Company and lawsuits against end users violating theCompany’s intellectual property and contractual rights.  The law firms are also representing theCompany in its lawsuits against IBM, Red Hat, Novell, AutoZone, andDaimlerChrysler.

 

In addition to receiving fees at reduced hourly rates,the Company’s agreement with the law firms provides that the law firms willreceive a contingency fee of 20 percent of the proceeds from specified eventsrelated to the protection of the Company’s intellectual property rights.  These events may include settlements,judgments, licensing fees, subject to certain exceptions, and a sale of theCompany during the pendancy of litigation or through settlement, subject toagreed upon credits for amounts received as discounted hourly fees and unused retainerfees.  Additionally, the Company’sagreement with the law firms may also be construed to include contingency feepayments in connection with the Company’s issuance of equity securities.  Future payments payable to the law firmsunder this arrangement may be significant.

 

As described in more detail in Note 10, the Companyand Boies Schiller & Flexner, LLP (“BSF”) have entered into anonbinding letter of intent to enter into a revised definitive feeagreement.  The revised definitive feeagreement has not yet been completed.

 

**Tax Assessment on the Company’sIndian Branch**

 

During the three months ended April 30, 2004, theIndian branch of the Company’s United Kingdom subsidiary, The SCO Group, Ltd.received a withholding tax assessment from the Government of India Income TaxDepartment (“Tax Department”) in the amount of $477,000.  In the assessment the Tax Department deemedrevenue transactions to customers in India as royalty revenue which was subjectto a 15 percent withholding tax.  TheCompany believes that the Tax Department may pursue similar assessments for the2002 and 2003 periods, and has accrued the full amount of the withholding taxof $314,000 for those periods.  Theseamounts have been recorded in the Company’s provision for income taxes duringthe nine months ended July 31, 2004. Since the initial assessment, the Company has filed various appeals withthe Tax Department objecting to the assessment and will continue to vigorouslyoppose to the assessment.

 

**Grants ofUnregistered Stock Options; Potential Interest and Penalties Related toRescission Rights**

 

The Company believes certain shares and optionsgranted under its 1998 Stock Option Plan, 1999 Omnibus Stock Incentive Plan,2002 Omnibus Stock Incentive Plan and 2004 Omnibus Stock Incentive Plan andshares under its 2000 Employee Stock Purchase Plan (collectively, the “Plans”)were issued without complying with registration or qualification requirementsunder federal securities laws and the securities laws of certain states.  As a result, certain Plan participants have aright to rescind their purchases of shares under the Plans or recover damagesif they no longer own the shares or hold unexercised options, subject toapplicable statutes of limitations. Additionally, regulatory authorities may require the Company to payfines or impose other sanctions. Although the Company continues to evaluate the possible actions it maytake, the Company may make a rescission offer to certain Plan participants entitledto rescission rights subject to obtaining required regulatory approvals.

 

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The Company believes certain of its stock optiongrants made since February 2003 may have also violated applicable statesecurities laws even though holders have not exercised such options.  Although the Company is continuing toevaluate its potential rescission risk to option holders, the Company isconsidering making a rescission offer to certain option holders.  Because the options in question have not beenexercised, no amounts are recorded in permanent equity.  There are a number of factors that must beconsidered in determining what a rescission offer to option holders mayinvolve.  At the current time, theCompany is unable to determine and quantify all of the key factors for apotential rescission offer.

 

The Company believes that it is reasonably possiblethat some option holders may accept a rescission offer, but the Company isunable to estimate the number of participants who might accept a rescissionoffer and the amount of potential damages that it would be required to payunder a rescission offer.  Since any lossis considered reasonably possible but not estimable, the Company has notrecorded 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 or in connection with any rescission offer.  The Company believes that it is reasonablypossible that it may be required to pay interest and penalties, but it is notable to estimate an amount.

 

**(7) REDEEMABLE CONVERTIBLE PREFERRED STOCK**

 

On October 16, 2003, the Company issued 50,000shares of its redeemable Series A Convertible Preferred Stock (the “Series A”)for $1,000 per share.  The net proceedsfrom the sale of the Series A were $47,740,000.  The value of the Series A was classifiedoutside of permanent equity because of certain redemption features that wereoutside the control of the Company.

 

The terms of the Series A included a number ofconversion provisions that represented a derivative financial instrument underSFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities.”  The Company determined thatthe conversion feature allowing Series A holders to acquire common shareswas an embedded derivative that did not qualify as a scope exemption under theprovisions of EITF 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in a Company’s Own Stock.”  This required the Company to separatelyaccount for and record at fair value and mark-to-market the fair value of thederivative.  Changes in the fair value ofthe derivative were recorded in the Company’s statement of operations.  As of October 16, 2003, the Company,through the assistance of an independent valuation firm, determined the initialfair value of the derivative was $18,069,000. As of October 31, 2003, the fair value of the derivative was$15,224,000 and the decrease in fair value of $2,845,000 was recorded as changein fair value of derivative in other income in the statement of operations forfiscal year 2003.

 

As of January 31, 2004, the fair value of thederivative was $11,600,000, and the decrease in fair value of $3,624,000 wasrecorded as change in fair value of derivative in other income in the statementof operations for three months ended January 31, 2004.   On February 5, 2004, all outstanding Series Ashares were exchanged for shares of the Company’s Series A-1 ConvertiblePreferred Stock (the “Series A-1”), and, as a result, no Series Ashares remained outstanding as of February 5, 2004.  The exchange did not result in the Companyreceiving any additional proceeds.  As ofFebruary 5, 2004, the fair value of the derivative was $9,300,000 and thedecrease in fair

 

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value of $2,300,000 from January 31,2004 was recorded as change in fair value of derivative in other income in thestatement of operations for the three months ended April 30, 2004.

 

As of February 5, 2004, the Company, through theassistance of an independent valuation firm, determined the fair value of the Series A-1was $45,276,000.  The Company incurred$211,000 in offering costs in connection with the issuance of the Series A-1in the exchange for Series A, resulting in a net fair value of$45,065,000.  The difference of$6,305,000 in the fair value of the Series A-1 and the combined carryingvalue of the Series A and the related derivative was recorded as anon-cash dividend in the statements of operations for the three months ended April 30,2004.

 

**Conversion of Series A-1Shares and Transfer of Series A-1 Shares to BayStar**

 

On May 5, 2004, the Company receiveda notice from Royal Bank of Canada (“RBC”) one of the holders of the Series A-1shares, that RBC had elected to convert 10,000 Series A-1 shares into atotal of 740,740 shares of the Company’s common stock.  The converted Series A-1 shares werepurchased at a price of $1,000 per share and were converted into shares ofcommon stock based on a conversion price of $13.50 per share.  A total of $9,013,000 was recorded aspermanent equity as a result of this conversion.  Additionally, RBC informed the Company thatit had sold its remaining 20,000 Series A-1 shares to BayStar Capital II,L.P. (“BayStar”), which following such transfer held a total of 40,000 Series A-1shares.

 

**Agreement to Repurchase BayStar Capital Series A-1Shares**

 

On May 31, 2004, the Company entered into anagreement with BayStar to repurchase and retire BayStar’s 40,000 Series A-1shares.  Terms of the agreement requiredthe Company to pay to BayStar $13,000,000 in cash and issue 2,105,263 shares ofthe Company’s common stock.  Therepurchase price was payable and issuable upon the effectiveness of a shelfregistration statement covering the resale of the shares of common stock thatwould be issued to BayStar upon the closing of the repurchase.  On July 21, 2004, the SEC declared theCompany’s registration statement on Form S-3 effective, and, in accordancewith the terms of the repurchase agreement, the closing of the repurchase withBayStar closed as of that date (see Note 10). The fair value of the cash and common shares delivered to BayStar wasless than the carrying value of the remaining value of the Series A-1shares and the Company recorded a capital contribution for this difference asoutlined in the following table (in thousands):

 
| Fair value of  2,105,263 common shares                 |   | $      | 9,747   |   |
|--------------------------------------------------------|--------|--------|---------|--------|
| Cash  consideration                                    |   | 13,000 |    |
| Total value to  BayStar                                |   | 22,747 |    |
| Carrying value  of Series A-1 including dividends |   | 38,222 |    |
| Capital  contribution                                  |   | $      | (15,475 | )      |

 

**Dividends**

 

If the repurchase had not occurred, dividends on the Series A-1shares would have been paid after October 16, 2004, the first anniversaryof the original Series A private placement, quarterly at a rate of 8percent per annum, subject to annual increases of 2 percent per annum, not toexceed 12 percent per annum.  Althoughthe Company accrued dividends of $551,000 and

 

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$2,047,000 for the threeand nine months ended July 31, 2004, respectively, which reduced earningsto common stockholders, the Company will no longer accrue dividends onpreferred stock because the repurchase transaction with BayStar closed.  The Company never paid any dividends on the Series Aor Series A-1 shares.

 

**(8) COMMONSTOCK SUBJECT TO RESCISSION**

 

The Company believes certain shares and optionsgranted under the Plans were issued without complying with registration orqualification requirements under federal securities laws and the securitieslaws of certain states.  As a result,certain Plan participants have a right to rescind their purchases of sharesunder the Plans or recover damages if they no longer own the shares or holdunexercised options, subject to applicable statutes of limitations.  Additionally, regulatory authorities mayrequire the Company to pay fines or impose other sanctions.  Although the Company continues to evaluatethe possible actions it may take, the Company may make a rescission offer tocertain Plan participants entitled to rescission rights subject to obtainingrequired regulatory approvals.

 

Accounting Series Release (“ASR”) No. 268and Emerging Issues task Force (“EITF”) Topic D-98 requires that stock subjectto rescission or redemption requirements outside the control of the Company tobe classified outside of permanent equity. The exercise of rescissionrights are at the holders’ discretion, but whether they exercise such rightsmay depend in part on the fair value of the Company’s common stock, which isoutside of the Company’s and the holders’ control.  Consequently, common stock subject torescission is classified as temporary equity. If the Company’s possible rescission offer is made and accepted by Planparticipants holding shares acquired under the Plans or otherwise entitled torecover damages from the Company in respect of such shares they have sold, orsuch Plan participants otherwise make rescission claims against the Company,the Company could be liable to make aggregate payments to these Planparticipants of up to $557,000 in the aggregate, excluding interest and otherpossible fees, based upon shares outstanding under the Plans as of July 31,2004.

 

In the event the Company completes a rescission offeror Plan participants otherwise exercise rescission rights, any amounts theCompany may pay to Plan participants, excluding interest and other possiblecharges, will be deducted from common stock subject to rescission, and, in theevent a Plan participant declines a rescission offer or otherwise isdetermined  to no longer have arescission right, any remaining amounts recorded to common stock subject torescission will be recorded as permanent equity.

 

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**(9) STOCKHOLDERS’EQUITY**

 

**Stock-BasedCompensation**

 

The following table details the components ofstock-based compensation for the three and nine months ended July 31, 2004and 2003 (in thousands):

 
| ** **                                | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                      |       |                                 |       |                                |       |   |   |   |   |
| Amortization of  stock-based compensation |       | $                                    | 51         |                                | $          | 235 |   | $ | 274 |   | $ | 631 |   |
| Options and  shares for services          |       | 219                                  |       | 74                                  |       | 502 |   | 296 |   |
| Modifications to  options                 |       | —                               |       | —                              |       | 92 |   | — |   |
| Total                                     |       | $                                    | 270        |                                | $          | 309 |   | $ | 868 |   | $ | 927 |   |

 

During the three and nine months ended July 31,2004, the Company granted options to purchase 346,000 and 878,000 shares ofcommon stock with an average exercise price of $4.76 and $7.56 per share,respectively.  None of these stockoptions was granted with an exercise price below the quoted market price on thedate of grant.  During the three and ninemonths ended July 31, 2004, options to purchase approximately 32,000 and400,000 shares of common stock were exercised with an average exercise price of$1.00 and $1.48 per share, respectively. As of July 31, 2004, there were 3,548,000 stock options outstandingwith a weighted average exercise price of $4.11 per share.

 

During the three months ended January 31, 2004,the Company modified an option grant to one of its board members.  The Company recognized compensation expenseof approximately $92,000 related to the modification of this option.

 

**Options to Consultants**

 

During the three monthsended April 30, 2004, the Company entered into an agreement with aconsultant to provide financial consulting and investor relations services tothe Company.  The agreement was for aperiod of three months and was renewable for additional three-monthperiods.  The Company paid the consultanta fixed fee of $10,000 per month.  Aspart of the agreement, the Company granted to the consultant an option toacquire 200,000 shares of the Company’s common stock at a price of $10.03 pershare, the fair value of the Company’s common stock on the date the agreementwas finalized.    The option expiredunexercised and the agreement with the consultant was not renewed.

 

The Company used theBlack-Scholes option pricing model to determine the fair value of the option of$269,000, of which $50,000 was recorded as expense in the three months ended April 30,2004 and the remaining $219,000 was recorded as expense in the three monthsended July 31, 2004.  Assumptionsused in the Black-Scholes option pricing model to determine the fair value ofthe option were the following: risk free interest rate of 2.9 percent,volatility of 66 percent, dividend yield of 0 percent, and a contractual termof three months.

 

**StockBuyback Program**

 

On March 10, 2004,the Company’s board of directors authorized management, in its discretion, topurchase up to 1,500,000 shares of the Company’s common stock over the 24-month

 

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period following March 10, 2004, the time at which the repurchaseprogram was effective.  Any repurchasedshares will be held in treasury and will be available for general corporatepurposes.  The repurchase program willallow the Company to repurchase its shares from time to time in accordance withthe requirements of the Securities and Exchange Commission on the open market,in block trades and in privately negotiated transactions, depending on marketconditions and other factors.  During thethree months ended April 30, 2004, the Company purchased approximately290,000 shares of its common stock at a total cost of approximately$2,414,000.  There were no repurchases ofcommon stock during the three months ended July 31, 2004.

 

**(10) SIGNIFICANTCUSTOMERS**

 

During the three and nine months ended July 31,2004, no single customer accounted for more than 10 percent of totalrevenue.  During the three months ended July 31,2003, Microsoft Corporation (“Microsoft”) accounted for approximately 25percent of total revenue and Sun Microsystems (“Sun”) accounted forapproximately 12 percent of total revenue. During the nine months ended July 31, 2003, Microsoft accounted forapproximately 16 percent of total revenue and Sun accounted for approximately12 percent of total revenue.

 

**(11)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.  Bothsegments are based on the Company’s UNIX intellectual property.  The UNIX business sells and distributes UNIXproducts and services through an extensive distribution channel and tocorporate end-users and the SCOsource business enforces and protects theCompany’s UNIX intellectual property.

 

During the third quarter of fiscal year 2004, in aneffort to maximize the assets and resources of the UNIX and SCOsource businesssegments and to best represent management’s view of business operations, theCompany began allocating resources and reviewing financial information for itsUNIX and SCOsource segment.  Thefollowing table presents the results of the SCOsource segment during the threeand nine months ended July 31, 2003. All costs associated with the SCOsource segment were classified as costof revenue for the three and nine months ended July 31, 2003 and therewere no direct sales or marketing efforts during these periods.

 

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Segment disclosures for the Company are as follows forthe three and nine months ended July 31, 2004 and 2003 (in thousands):

 
| ** **                     | ** ** | **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                   |       | 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 | ) |

 
| ** **                     | ** ** | **Three Months Ended July 31, 2003** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|
| ** **                     | ** ** | **UNIX**                                  | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                           |       |                                      |       |   |   |   |   |
| Revenue                        |       | $                                         | 12,775     |   | $ | 7,280 |   | $ | 20,055 |   |
| Cost of revenue                |       | 2,738                                     |       | 1,796 |   | 4,534 |   |
| Gross margin                   |       | 10,037                                    |       | 5,484 |   | 15,521 |   |
| Sales and  marketing           |       | 5,930                                     |       | — |   | 5,930 |   |
| Research and  development      |       | 2,950                                     |       | — |   | 2,950 |   |
| General and  administrative    |       | 1,413                                     |       | — |   | 1,413 |   |
| Other                          |       | 1,818                                     |       | — |   | 1,818 |   |
| Total operating  expenses      |       | 12,111                                    |       | — |   | 12,111 |   |
| Income (loss)  from operations |       | $                                         | (2,074     | ) | $ | 5,484 |   | $ | 3,410 |   |

 
| ** **                  | ** ** | **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                |       | 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 |       | 6,325                                    |       | 150 |   | 6,475 |   |
| Other                       |       | 4,980                                    |       | — |   | 4,980 |   |
| Total operating  expenses   |       | 32,011                                   |       | 1,563 |   | 33,574 |   |
| Loss from  operations       |       | $                                        | (5,623     | ) | $ | (16,340 | ) | $ | (21,963 | ) |

 

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| ** **                     | ** ** | **Nine Months Ended July 31, 2003** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|
| ** **                     | ** ** | **UNIX**                                 | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                           |       |                                     |       |   |   |   |   |
| Revenue                        |       | $                                        | 39,434     |   | $ | 15,530 |   | $ | 54,964 |   |
| Cost of revenue                |       | 8,430                                    |       | 4,129 |   | 12,559 |   |
| Gross margin                   |       | 31,004                                   |       | 11,401 |   | 42,405 |   |
| Sales and  marketing           |       | 18,421                                   |       | — |   | 18,421 |   |
| Research and  development      |       | 8,142                                    |       | — |   | 8,142 |   |
| General and  administrative    |       | 4,525                                    |       | — |   | 4,525 |   |
| Other                          |       | 3,720                                    |       | — |   | 3,720 |   |
| Total operating  expenses      |       | 34,808                                   |       | — |   | 34,808 |   |
| Income (loss)  from operations |       | $                                        | (3,804     | ) | $ | 11,401 |   | $ | 7,597 |   |

 

The following table presents revenue by geography (inthousands):

 
| ** **    | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **    | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:      |       |                                 |       |                                |       |   |   |   |   |
| Americas      |       | $                                    | 6,277      |                                | $          | 14,265 |   | $ | 18,927 |   | $ | 36,649 |   |
| International |       | 4,928                                |       | 5,790                               |       | 13,807 |   | 18,315 |   |
| Total revenue |       | $                                    | 11,205     |                                | $          | 20,055 |   | $ | 32,734 |   | $ | 54,964 |   |

 

Intangible assets, which consist of our resellerchannel, trade name and technology, have been assigned to our UNIX andSCOsource segments and consist of the following as of July 31, 2004 (inthousands): 

 
| ** **                              | ** ** | **July 31,  2004** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| Intangible  assets:                     |       |                    |       |
| UNIX (reseller  channel and trade name) |       | $                       | 5,333      |   |
| SCOsource  (technology)                 |       | 757                     |       |
| Total intangible  assets                |       | $                       | 6,090      |   |

 

**(12) SUBSEQUENT EVENTS**

 

**BayStar Capital**

 

On August 24, 2004, the Companydelivered to BayStar $13,000,000 in cash and a stock certificate representing2,105,263 common shares of the Company’s common stock.  The Company delivered cash and stockconsideration in connection with its repurchase of BayStar’s 40,000 Series A-1Shares pursuant to a stock repurchase agreement entered into between them on May 31,2004 (as described in Note 5 above).  Theclosing of the repurchase transaction occurred on July 21, 2004.  As of July 31, 2004, prior to BayStar’sacceptance of the consideration, the Company classified this cash as restrictedcash and recorded a payable to BayStar.

 

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**Agreement with Boies, Schiller & Flexner,LLP**

 

On August 31, 2004, the Company announced it had entered into anonbinding letter of intent with BSF, to revise the existing fee agreement withBSF to limit the Company’s overall future cash costs of legal fees, including accruedlegal fees to BSF as of July 31, 2004, associated with the Company’spending intellectual property litigation to a total of $31,000,000.  Inaddition, the nonbinding letter of intent contemplates that BSF will lead theCompany’s intellectual property legal efforts through the duration andcompletion of the pending litigation.  Inreturn for the new fee arrangement, the nonbinding letter of intent providesthat the contingency fee payable to BSF and other law firms associated with anysettlement or judgment award will vary on a scaled basis from 20 to 33 percent,depending on the size of the award.  Therevised fee agreement is subject to the Company and BSF entering into adefinitive revised fee agreement.

 

**Stockholder Rights Plan**

 

On August 10, 2004, the Company’sBoard of Directors adopted a Stockholder Rights Plan (the “Rights Plan”)designed to deter coercive takeover tactics, including accumulation of sharesin the open market or through private transactions and to prevent an acquirerfrom gaining control of the Company without offering a fair price to all of theCompany’s stockholders.

 

Under the terms of the Rights Plan, Series AJunior Participating Preferred Stock purchase rights will be distributed as adividend at the rate of one right for each share of common stock of the Companyheld by stockholders of record as of the close of business on August 30,2004.  The Rights Plan would be triggeredif a person or group acquired beneficial ownership of 15 percent or more of theCompany’s common stock other than pursuant to a board-approved tender orexchange offer or commences, or publicly announces an intention to commence, atender or exchange offer upon consummation of which such person or group wouldbeneficially own 15 percent or more of the Company’s common stock.

 

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**ITEM 2****.****                                                    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 Amendment No. 1 to Form 10-Q contain forward-lookingstatements that involve risks and uncertainties.  Forward-looking statements can also beidentified by words such as “intends,” “anticipates,” “expects,” “believes,” “plans,”“predicts,” and similar terms. Forward-looking statements are not guarantees of future performance andour actual results may differ significantly from the results discussed in theforward-looking statements.  Factors thatmight cause such differences include, but are not limited to, those set forthbelow under “Forward-Looking Statements” and “Risk Factors” and elsewhere inthis Amendment No. 1 to Form 10-Q. The following discussion should be read in conjunction with ourconsolidated financial statements and notes thereto included in this Amendment No. 1to Form 10-Q and our annual report on Form 10-K for the year ended October 31,2003 filed with the Securities and Exchange Commission, including the auditedfinancial statements and management’s discussion and analysis containedtherein.  All information presentedherein is based on the three and nine months ended July 31, 2004.  We assume no obligation to revise or updateany forward-looking statements for any reason, except as required by law.*

 

**Restatement of Financial Statements**

 

As discussed in Note 2 to the Financial Statements,the Company’s condensed consolidated financial statements as of and for thethree and nine months ended July 31, 2004 have been restated.  The accompanying management’s discussion andanalysis gives effect to that restatement.

 

**Overview**

 

*Historical Background. *We originally incorporatedas Caldera Systems, Inc., a Utah corporation (“Caldera Systems”), andreincorporated as a Delaware corporation on March 6, 2000.  In March 2000, we completed an initialpublic 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, CalderaSystems became a wholly-owned subsidiary of Caldera International, Inc.  Former holders of shares and optionsto purchase shares of Caldera Systems received an equal number of shares andoptions to purchase shares in CalderaInternational, Inc.  On May 16, 2003, our stockholdersapproved our corporate name change to The SCO Group, Inc.

 

*RecentDevelopments.*  On August 31, 2004, we announced wehad entered into a nonbinding letter of intent with Boies, Schiller &Flexner, LLP (“BSF”), to revise the existing fee agreement with BSF to limitour overall future cash costs of legal fees, including accrued legal fees toBSF as of July 31, 2004, associated with our pending intellectual propertylitigation to a total of $31,000,000.  In addition, the nonbinding letterof intent contemplates that BSF will lead our intellectual property legalefforts through the duration and completion of the pending litigation.  In return for the new fee arrangement, thenonbinding letter of intent provides that the contingency fee payable to BSFand other law firms associated with any settlement or judgment award will varyon a scaled basis from 20 to 33 percent, depending on the size of theaward.  The revised fee agreement issubject to the Company and BSF entering into a definitive revised feeagreement.

 

On August 10, 2004, our Board ofDirectors adopted a Stockholder Rights Plan (the “Rights Plan”) designed todeter coercive takeover tactics, including accumulation of shares in the openmarket or through private transactions and to prevent an acquirer from gainingcontrol of our company without offering a fair price to all of ourstockholders.

 

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Under the terms ofthe Rights Plan, preferred stock purchase rights will be distributed as adividend at the rate of one right for each share of common stock of the Companyheld by stockholders of record as of the close of business on August 30,2004.  The Rights Plan would be triggeredif a person or group acquired beneficial ownership of 15 percent or more of ourcommon stock other than pursuant to a board-approved tender or exchange offeror commences, or publicly announces an intention to commence, a tender orexchange offer upon consummation of which such person or group wouldbeneficially own 15 percent or more of our common stock.  The adoption of the Rights Plan had no impacton the financial statements for the third quarter or first three quarters offiscal year 2004.  However, if atriggering event occurs in the future, there may be an impact to the financialstatements at the time a triggering event occurs.

 

On May 31,2004, we entered into an agreement with BayStar to repurchase and retireBayStar’s 40,000 Series A-1 shares. Terms of the agreement required us to pay to BayStar $13,000,000 in cashand issue 2,105,263 shares of our common stock, which consideration was payableand issuable upon closing, which was the effectiveness of a registrationstatement covering the resale of the common stock issued to BayStar.  The registration statement was declaredeffective by the SEC on July 21, 2004, the transaction closed as of thatdate, all Series A-1 shares were cancelled and retired and the rights andpreferences of the Series A-1 shares were terminated.  The transaction also eliminated BayStar’scontractual rights and includes a general release by both parties.  The Company delivered the $13,000,000 in cashand 2,105,263 common shares to BayStar on August 24, 2004.

 

On May 5,2004, we received a notice from RBC of its election to convert 10,000 shares ofour Series A-1 Convertible Preferred Stock into a total of 740,740 sharesof our common stock.  Additionally, RBCinformed us that it sold its remaining 20,000 Series A-1 shares toBayStar, making BayStar the sole holder of all 40,000 outstanding Series A-1shares.

 

On February 5,2004, we completed a transaction pursuant to an exchange agreement among us, BayStar Capital II, L.P. (“BayStar”) andRoyal Bank of Canada (“RBC”) in which each outstanding share of ourthen-outstanding redeemable Series A Convertible Preferred Stock wasexchanged for one share of our new redeemable Series A-1 ConvertiblePreferred Stock.

 

With respect to our legalaction against IBM, on March 3, 2004, the U.S. Magistrate Judge issued anorder addressing certain discovery matters relating to both IBM and us.  We filed a motion to dismiss IBM’s tenthcounterclaim for a declaratory judgment of non-infringement of copyrights and amotion to amend the scheduling order and a motion to bifurcate IBM’s patentcounterclaims into another action.  Wefiled, on May 28, 2004, a reply brief in connection with its motion toamend the scheduling order, in which we set forth detailed and specificresponses to IBM’s claims made in connection with that motion.  A hearing for these motions was held on June 8,2004, and the court issued its ruling on June 10, 2004.  The court granted our motion to amend thescheduling order, with certain changes. The amended scheduling order now provides, among other things, that thedeadline for completing fact discovery is February 11, 2005 (previously August 4,2004), the deadline for completing expert discovery is April 22, 2005(previously October 22, 2004), and the trial will begin on November 1,2005 (previously April 11, 2005). The court also denied our motion to bifurcate IBM’s patent counterclaimswithout prejudice to our right to request a bifurcation again at a laterdate.  IBM has also filed a motion forpartial summary judgment on its tenth counterclaim for a declaration ofnon-infringement of our copyrights.  Ahearing regarding our motion to dismiss and IBM’s motion for partial summaryjudgment on IBM’s tenth counterclaim for a declaration of non-infringement iscurrently scheduled for September 15, 2004.  We plan to vigorously oppose IBM’smotion.  The Company has filed variousmotions seeking additional discovery from IBM. IBM has filed two additional motions for summary judgment which theCompany will vigorously oppose.  Inaddition to the materials that have been publicly filed with the court, certaininformation has been filed under seal in accordance with the protective orderentered in the case.

 

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On orabout January 20, 2004, we brought suit against Novell, Inc. (“Novell”)for slander of title seeking relief for Novell’s alleged bad faith efforts tointerfere with our ownership of copyrights related to our UNIX source code andderivative works and our UnixWare product. In the lawsuit, we request preliminary and permanent injunctive reliefas well as damages. Through our claims, we seek to require Novell to assign tous all copyrights that we believe Novell has wrongfully registered, preventNovell from representing any ownership interest in those copyrights and requireNovell to retract or withdraw all representations it has made regarding itspurported ownership of those copyrights. On June 10, 2004, the court issued a memorandum decision and orderwhich denied our motion to remand the case to state court.  The memorandum decision also denied Novell’smotion to dismiss in part on claims of falsity. However, the court granted Novell’s motion to dismiss regarding ourallegations of special damages, but granted us 30 days leave to amend ourcomplaint and plead special damages with more specificity.  The Company has filed its amended complaintand Novell has responded with another motion to dismiss claiming that Novell’salleged slanderous statements are privileged under the law.

 

On orabout March 2, 2004, we brought suit against AutoZone, Inc. for itsalleged violations of our UNIX copyrights through its use of Linux.  Specifically, the lawsuit alleges thatAutoZone is infringing our UNIX copyrights by, among other things, runningversions of the Linux operating system that contain code, structure, sequenceand/or organization from our proprietary UNIX System V code in violation of ourcopyrights.  The lawsuit filed in U.S.District Court in Nevada requests injunctive relief against AutoZone’s furtheruse or copying of any part of our copyrighted materials and also requestsdamages as a result of AutoZone’s infringement in an amount to be proven attrial.  On April 23, 2004, AutoZonefiled a motion to transfer the case to Tennessee or to stay the case.  On August 6, 2004, the federal court inNevada entered an order granting AutoZone’s motion to stay the case with 90days status reports to the court.  Thecourt denied without prejudice AutoZone’s motion for a more definite statementand its motion to transfer the case to Tennessee.  The court also is allowing the parties totake limited expedited discovery relating to the issue of preliminaryinjunctive relief requested by us.  Weare undertaking that discovery process.

 

On or about March 3, 2004, we brought suitagainst DaimlerChrysler Corporation for its alleged violations of its UNIXsoftware agreement with us. Specifically, the lawsuit alleges that DaimlerChrysler breached its UNIXsoftware agreement with us by failing to voluntarily certify by January 31,2004 its compliance with its UNIX software agreement as required by us.  The lawsuit, filed in Oakland County CircuitCourt in the State of Michigan, requests the court to declare thatDaimlerChrysler has violated the certification requirements of its UNIXsoftware agreement, permanently enjoin DaimlerChrysler from further violationsof the UNIX software agreement, issue a mandatory injunction requiringDaimlerChrysler to remedy the effects of its past violations of the UNIXsoftware agreement and award us damages in amount to be determined at trialtogether with costs, attorneys’ fees and any such other or different reliefthat the Court may deem to be equitable and just.  On April 15, 2004, DaimlerChrysler fileda motion to dismiss our claims. DaimlerChrysler’s motion was heard on July 21, 2004 and the courtgranted DaimlerChrysler’s motion as to the substance of DaimlerChrysler’scertification, but denied the motion as to whether the certification wastimely.  We are currently evaluating thismatter and potential further actions we may take.

 

In March 2004, our board of directors authorizedmanagement, in its discretion, to purchase up to 1,500,000 shares of our commonstock over a 24-month period.  Shares maybe purchased in open market transactions, block purchases or privatelynegotiated transactions.  Any repurchasedshares will be held as treasury stock and will be available for generalcorporate purposes.  During the quarterended April 30, 2004, we purchased 290,000 shares of our common stock inopen market purchases for a total cost of $2,414,000.  We did not purchase any shares of our commonstock during the quarter ended July 31, 2004.

 

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**BusinessFocus**

 

We generate revenueprimarily from two sources: product and services revenue from our UNIX businessand license fees from our SCOsource business.

 

*UNIX Business. *Our UNIXbusiness serves the needs of small-to-medium sized businesses, includingreplicated site franchisees of Fortune 1000 companies, by providing reliable,cost effective UNIX operating systems and software products to power computersrunning on Intel architecture.  Ourlargest source of UNIX business revenue is derived from existing customersthrough our worldwide, indirect, leveraged channel of partners which includesdistributors and independent solution providers.  We have local offices in a number ofcountries that provide support and services to customers and resellers in thesecountries.  The other principal channelfor selling and marketing our UNIX products is through existing customers thathave a large number of replicated sites or franchisees.  We access these corporations through theirinformation technology or purchasing departments with our Area Sales Managersin the United States and through our reseller channel in countries outside theUnited States.  In addition, we also sellour operating system products to OEMs.  Our sales of UNIX products andservices during the third quarter and first three quarters of fiscal year 2004were primarily to pre-existing UNIX customers, and not newly acquiredcustomers.  Our UNIX business revenuedepends significantly on our ability to market our products to existingcustomers and to generate upgrades from existing customers.  The following table shows the operatingresults of the UNIX business for the three and nine months ended July 31,2004 and 2003 (in thousands):

 
| ** **                     | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                     | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                           |       |                                 |       |                                |       |   |   |   |   |
| Revenue                        |       | $                                    | 10,527     |                                | $          | 12,775 |   | $ | 32,025 |   | $ | 39,434 |   |
| Cost of revenue                |       | 1,619                                |       | 2,738                               |       | 5,637 |   | 8,430 |   |
| Gross margin                   |       | 8,908                                |       | 10,037                              |       | 26,388 |   | 31,004 |   |
| Sales and  marketing           |       | 3,740                                |       | 5,930                               |       | 12,868 |   | 18,421 |   |
| Research and  development      |       | 2,361                                |       | 2,950                               |       | 7,838 |   | 8,142 |   |
| General and  administrative    |       | 1,761                                |       | 1,413                               |       | 6,325 |   | 4,525 |   |
| Other                          |       | 863                                  |       | 1,818                               |       | 4,980 |   | 3,720 |   |
| Total operating  expenses      |       | 8,725                                |       | 12,111                              |       | 32,011 |   | 34,808 |   |
| Income (loss)  from operations |       | $                                    | 183        |                                | $          | (2,074 | ) | $ | (5,623 | ) | $ | (3,804 | ) |

 

Revenue from our UNIXbusiness decreased by $2,248,000, or 18 percent, for the third quarter offiscal year 2004 compared to the third quarter of fiscal year 2003, and revenuefrom our UNIX business decreased by $7,409,000, or 19 percent, for the firstthree quarters of fiscal year 2004 compared to the first three quarters offiscal year 2003.  The revenue from thisbusiness has been declining over the last several quarters primarily as aresult of increased competition from alternative operating systems,particularly Linux, and lower information technology spending for UNIXproducts.  Until the third quarter offiscal year 2004, our UNIX business had generated losses from operations forseveral quarters.  If revenue fromour UNIX business continues to decline and we are unable to generate andsustain positive cash flow and profitable operations, our UNIX operations maybe adversely impacted.

 

In an effort to attainprofitability in our UNIX business, we have decreased our operating costs andincreased our gross margin percentage over the last two quarters.  Operating costs for our UNIX businessdecreased from $12,111,000 for the third quarter of fiscal year 2003 to$8,725,000 for the third quarter of fiscal year 2004, and decreased from$34,808,000 for the first three quarters of fiscal year 2003 to $32,011,000 forthe first three quarters of fiscal year 2004. These cost reductions have primarily been attributable to reducedheadcount and continued

 

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operationalefficiencies generated in our UNIX business. We have reduced the number of employees in our UNIX business from 324 asof July 31, 2003 to 223 as of July 31, 2004, eliminated redundantfacilities and reduced other discretionary spending while still preserving ourworldwide infrastructure.  During thefourth quarter of fiscal year 2004, we plan to take additional cost reductionactions, which will include reductions in staff as well as certain reductionsand consolidation in office space, which will further decrease the operatingcosts of our UNIX business.  We estimatethat the restructure cost associated with these actions may be approximately$2,000,000, but the actual cost associated with these actions may differ fromthis estimate.

 

Our gross margin percentagefrom our UNIX business also increased from 79 percent in the third quarter offiscal year 2003 to 85 percent in the third quarter of fiscal year 2004.  We may not be able to sustain profitabilityin our UNIX business through additional operating cost reductions.

 

The decline in our UNIXbusiness revenue may be accelerated if industry partners withdraw their supportas a result of our SCOsource initiatives and, in particular, any lawsuitsagainst end users violating our intellectual property and contractualrights.  The decline in our UNIX businessand our SCOsource initiatives, particularly lawsuits against such end users,may cause industry partners, developers and hardware and software vendors tochoose not to support or certify to our UNIX operating system products.  This would lead to an accelerated decline inour UNIX products and services revenue.

 

An important initiative forour UNIX business for the 2004 fiscal year has been our continued investment inand commitment to our UNIX operating systems. As part of this initiative, we released a new version of our UnixWareoperating system in June 2004 and anticipate releasing a new version ofour OpenServer operating system in the first calendar quarter of 2005 and willprovide these products with increased system reliability, backwardcompatibility with existing applications and software, increased applicationand hardware support, integration with widely used internet applications andincreased system performance.   Theseenhancements will not have a direct impact on our short-term UNIX revenuebecause of the long adoption cycle for new operating system purchases and ourlong operating system product sales cycle, but we believe that they will helpprolong our UNIX revenue stream for future quarters.

 

*SCOsource Business. *During the 2003 fiscal year, we became aware that our UNIX code andderivative works had been inappropriately included in the Linux operatingsystem.  We believe the inclusion of ourUNIX code and derivative works in Linux has been a major contributor to thedecline in our UNIX business because users of Linux generally do not pay forthe operating system but only minimal fees, if any, for service and maintenance.  The Linux operating system competes directlywith our OpenServer and UnixWare products and has taken significant marketshare from these products.

 

In an effort to protect ourUNIX intellectual property, we initiated our SCOsource licensing initiatives.  These initiatives now include seeking toenter into license agreements with UNIX vendors and offering SCOsourceintellectual property (“IP”) licenses to Linux end users allowing them tocontinue to use our UNIX source code and derivative works found in Linux.  Our SCOsource efforts resulted in theexecution of two significant vendor license agreements during fiscal year 2003.

 

During fiscal year 2004, we began allocating resourcesand reviewing financial information for SCOsource business.  The following table shows the results ofoperations for the SCOsource business for the third quarter and first threequarters of fiscal year 2004 as well as for the third quarter and first threequarters of fiscal year 2003 had the SCOsource business existed.

 

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There were no directcosts associated with selling, marketing, research and development and generaland administration for the 2003 periods. The following tableshows the operating results of the SCOsource business for the three and ninemonths ended July 31, 2004 and 2003 (in thousands):

 
| ** **                     | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                     | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                           |       |                                 |       |                                |       |   |   |   |   |
| Revenue                        |       | $                                    | 678        |                                | $          | 7,280 |   | $ | 709 |   | $ | 15,530 |   |
| Cost of revenue                |       | 7,396                                |       | 1,796                               |       | 15,486 |   | 4,129 |   |
| Gross margin                   |       | (6,718                               | )          | 5,484                               |       | (14,777 | ) | 11,401 |   |
| Sales and  marketing           |       | 493                                  |       | —                              |       | 1,084 |   | — |   |
| Research and  development      |       | 231                                  |       | —                              |       | 329 |   | — |   |
| General and  administrative    |       | 128                                  |       | —                              |       | 150 |   | — |   |
| Other                          |       | —                               |       | —                              |       | — |   | — |   |
| Total operating  expenses      |       | 852                                  |       | —                              |       | 1,563 |   | — |   |
| Income (loss)  from operations |       | $                                    | (7,570     | )                                   | $          | 5,484 |   | $ | (16,340 | ) | $ | 11,401 |   |

 

Our future success with ourSCOsource initiatives and future revenue from SCOsource licenses will depend onour ability to protect our UNIX intellectual property.   We will continue to devote resources to ourSCOsource initiatives, but we expect quarterly legal fees and other SCOsourcerelated costs to vary from quarter to quarter depending upon the level of, andactivity surrounding, our intellectual property claims, and therefore aredifficult to predict.  Asexplained above in this Item 2 under the caption “Recent Developments,” we haveentered into a nonbinding letter of intent with BSF, our outsidelitigation legal counsel, to revise the existing fee agreement with BSF.  Upon completing the revised agreement, weexpect we will limit our future cash costs of legal fees, including accruedlegal fees to BSF as of July 31, 2004, associated with our pendingintellectual property litigation to a total of $31,000,000.  In addition,the nonbinding letter of intent contemplates that the contingency fee payableto BSF and other law firms associated with any settlement or judgment award,which is currently set at 20 percent, will vary on a scaled basis from 20 to 33percent, depending on the size of the award. Events that may trigger a contingency fee may include settlements,judgments, licensing fees, subject to certain exceptions, and a sale of ourcompany during the pendancy of litigation or through settlement, subject toagreed upon credits for amounts received as discounted hourly fees and unusedretainer fees.  Additionally, our currentagreement with our law firms may also be construed to include contingency feepayments in connection with any issuance of our equity securities, although weintend to eliminate this contingency in the revised fee agreement.  The revised fee agreement is subject to BSFentering into a definitive revised fee agreement with us.

 

Because of the uncertainties related to our SCOsourcebusiness, we are unable to estimate the amount and timing of future SCOsourcelicensing revenue as well as predict the ultimate level of spending on ourlawsuits.  This uncertainty represents asignificant risk and challenge for us, both in the short and long term.  If we do receive revenue from this source, itmay be sporadic and fluctuate from quarter to quarter.  Our SCOsource initiatives are unlikely toproduce a stable or predictable revenue stream for the foreseeable future.  Additionally, the success of theseinitiatives may depend on the strength of our intellectual property rights andcontractual claims regarding UNIX, including the strength of our claim thatunauthorized UNIX source code and derivative works are prevalent in Linux.

 

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**Critical Accounting Policies**

 

Our critical accountingpolicies and estimates include the following:

 

•                                          Revenue recognition;

 

•                                          Deferred income taxes and related valuationallowances;

 

•                                          Fair value of derivative financial instrumentand our now retired Series A-1 Convertible Preferred Stock;

 

•                                          Impairment of long-lived assets; and

 

•                                          Allowances for doubtful accounts.

 

*Revenue Recognition*.  We recognize revenue in accordance withStatement of Accounting Position (“SOP”) 97-2, as amended, and Staff AccountingBulletin (“SAB”) 104.  Revenuerecognition in accordance with these pronouncements can be complex due to thenature and variability of our sales transactions.  We recognize products revenue and SCOsourcerevenue upon shipment if a signed contract exists, the fee is fixed anddeterminable, collection of the resulting receivable is probable and productreturns are reasonably estimable, except for sales to distributors, which arerecognized upon sale by the distributor to end users.  We recognize product revenue from royaltypayments upon receipt of quarterly royalty reports from OEMs related to theirproduct sales.

 

The majority of our revenue transactions relate toproduct sales only.  On occasion we haverevenue transactions that include multiple elements (such as delivered andundelivered elements including maintenance, support and other services).  For invoices or contracts involving multipleelements, we allocate revenue to each component of the contract based onobjective evidence of its fair value. The fair value of each element is based on amounts charged when suchelements are sold in separate transactions. We recognize revenue allocated to undelivered products when the criteriafor revenue recognition set forth above have been met.

 

Estimates used in our revenue recognition include thedetermination of credit-worthiness and verification of sales-out reporting toend users through our two-tier distribution channel.  We also provide reserves against revenuebased on historical trends and experience. To the extent these estimates were incorrect our recognized revenuewould be adversely impacted and would harm our results of operations.  Additionally, if our business conditionschange or our revenue contracts begin to contain more multiple elements, ourrevenue recognition in future periods may be impacted because a largercomponent of revenue may be deferred.  Asof July 31, 2004, our deferred revenue balance was $5,936,000 and relatedprimarily to product maintenance and support contracts.

 

*Deferred Income Taxes and RelatedValuation Allowance*. The amount, and ultimate realization, of our deferred income tax assetsdepends, in part, upon the tax laws in effect, our future earnings and otherfuture events, the effects of which cannot be determined.  We have provided a valuation allowance of$52,908,000 against our entire net deferred tax asset as of October 31,2003.  The valuation allowance wasrecorded because of our history of net operating losses and the uncertaintiesregarding our future operating profitability and taxable income.

 

*Fair Value of Derivative FinancialInstrument and Our Retired Series A-1 Convertible Preferred Stock*.  On October 16, 2003, we issued 50,000shares of our redeemable Series A Convertible Preferred Stock for $1,000per share.  The net proceeds from thesale of the preferred stock were $47,740,000. The terms of the preferred stock included conversion and a number ofredemption provisions that represented a derivative financial instrument underSFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities,” as amended.  We determinedthat the

 

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conversion featureallowing the holders of the preferred stock to acquire common shares is anembedded derivative financial instrument that does not qualify as a scopeexemption under the provisions of Emerging Issues Task Force (“EITF”) 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in aCompany’s Own Stock.”

 

As of October 16, 2003, through the assistance ofan independent valuation firm, we determined the initial fair value of thederivative was $18,069,000 and the value of the preferred stock was$29,671,000.  We were required to accountfor the conversion feature as an embedded derivative since the preferred stockinstrument did not entitle the holders to equity features such as voting rightsand board representation.  As of October 31,2003, the fair value of the derivative was $15,224,000 and the decrease in fairvalue of $2,845,000 was recorded as change in fair value of derivative in otherincome in the statement of operations for fiscal year 2003.  As of January 31, 2004, the fair valueof the derivative was $11,600,000 and the decrease in fair value of $3,624,000was recorded as change in fair value of derivative in other income in ourcondensed consolidated statement of operations for the three months ended January 31,2004.

 

On February 5, 2004, we completed an exchangetransaction in which each outstanding Series A share was exchanged for oneshare of redeemable Series A-1 Convertible Preferred Stock.  We received no additional proceeds in theexchange.  The exchange transactioneliminated the derivative related to the Series A shares that wasinitially recorded as a current liability on our balance sheet and eliminatedthe charge in our quarterly statements of operations for the change in the fairvalue of the derivative related to the Series A shares.  The derivative was eliminated due to certainrights and privileges included in the new Series A-1 shares, such asvoting rights and rights to board representation, among others, that were notincluded in the Series A shares.

 

We recorded $2,300,000 as change in fair value of derivativein other income in the second quarter of fiscal year 2004 related to the changein the fair value of the derivative between January 31, 2004 and February 5,2004, the time at which the exchange agreement was executed.  Through the assistance of an independentvaluation firm, we determined the fair value of the Series A-1 shares tobe $45,276,000 as of February 5, 2004. We recorded a dividend in the second quarter of fiscal year 2004 of$6,305,000 related to the difference between the fair value of the Series A-1shares and the carrying value of the previously issued Series A shares andrelated derivative.  This dividendreduced earnings to common stockholders. The estimated fair value of the Series A-1 shares as of February 5was calculated using a binomial model. Specific assumptions used included: 2.7 years to maturity, 11 percentequivalent bond yield, risk-free rate of 2.4 percent, volatility of 130percent.  As described elsewhere in thisfiling, we repurchased all outstanding Series A-1 shares on July 21,2004.

 

*Impairment of Long-lived Assets*.  We review our long-lived assets forimpairment when events or changes in circumstances indicate that the book valueof 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-lived asset is considered impaired when theanticipated cumulative undiscounted cash flows of the related asset or group ofassets is less than the carrying value. In that event, a loss is recognized based on the amount by which thecarrying value exceeds the estimated fair market value of the long-lived asset.

 

We performed an impairment analysis as of April 30,2004 in accordance with SFAS No. 142, “Goodwill and Other IntangibleAssets”  and SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” and determined that thegoodwill and intangible assets related to the Vultus technology, which weacquired from Vultus, Inc. (“Vultus”) in June 2003, had beenimpaired.  We concluded that animpairment-triggering event occurred during the second quarter of fiscal year2004 as an impending partnership that would solidify the Vultus revenue andcash flow opportunities did not materialize. Additionally, we had a reduction in

 

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force that impacted ourability to move the Vultus initiative forward on a stand-alone basis.  Consequently, we have concluded that nosignificant future cash flows related to our Vultus assets would berealized.  As a result of these analyses,we wrote-down the carrying value of our goodwill related to the Vultusacquisition from $1,166,000 to $0 and wrote-down intangible assets related toour Vultus acquisition from $973,000 to $0.

 

Write-downs of intangible assets may be necessary ifthe future fair value of these assets is less than carrying value.  If the operating trends for our UNIX orSCOsource businesses continue to decline or the value of our common stock wereto significantly decrease, we may be required to record an impairment charge ina future period related to the carrying value of our intangible assets withfinite lives.

 

*Allowance for Doubtful Accounts*.  Weoffer credit terms on the sale of our products to a majority of our customersand require no collateral from these customers. 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 threeand nine months ended July 31, 2004. Our allowance for doubtful accounts, which is determined based on ourhistorical experience and a specific review of customer balances, was $126,000as of July 31, 2004.  Our pastexperience has resulted in minimal differences from the actual amounts providedfor bad debts and our recorded estimates. However, our actual bad debts in future periods may differ from ourcurrent estimates and the differences may be material, which may have anadverse impact on our future accounts receivable and cash position.

 

35

----

 

**Results of Operations**

 

Thefollowing table presents our results of operations for the three and ninemonths ended July 31, 2004 and 2003 (in thousands):

 
| ** **                                           | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                           | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Statement  of Operations Data:**                   |       |                                 |       |                                |       |   |   |   |   |
|                                                 |       |                                 |       |                                |       |   |   |   |   |
| Revenue:                                             |       |                                 |       |                                |       |   |   |   |   |
| Products                                             |       | $                                    | 8,929      |                                | $          | 10,804 |   | $ | 27,056 |   | $ | 33,016 |   |
| SCOsource  licensing                                 |       | 678                                  |       | 7,280                               |       | 709 |   | 15,530 |   |
| Services                                             |       | 1,598                                |       | 1,971                               |       | 4,969 |   | 6,418 |   |
| Total revenue                                        |       | 11,205                               |       | 20,055                              |       | 32,734 |   | 54,964 |   |
| Cost of revenue:                                     |       |                                 |       |                                |       |   |   |   |   |
| Products                                             |       | 741                                  |       | 1,200                               |       | 2,364 |   | 3,422 |   |
| SCOsource  licensing                                 |       | 7,396                                |       | 1,796                               |       | 15,486 |   | 4,129 |   |
| Services                                             |       | 878                                  |       | 1,538                               |       | 3,273 |   | 5,008 |   |
| Total cost of  revenue                               |       | 9,015                                |       | 4,534                               |       | 21,123 |   | 12,559 |   |
| Gross margin                                         |       | 2,190                                |       | 15,521                              |       | 11,611 |   | 42,405 |   |
| Operating expenses:                                  |       |                                 |       |                                |       |   |   |   |   |
| Sales and  marketing                                 |       | 4,233                                |       | 5,930                               |       | 13,952 |   | 18,421 |   |
| Research and  development                            |       | 2,592                                |       | 2,950                               |       | 8,167 |   | 8,142 |   |
| General and  administrative                          |       | 1,889                                |       | 1,413                               |       | 6,475 |   | 4,525 |   |
| Loss on  impairment of long-lived assets             |       | —                               |       | —                              |       | 2,139 |   | — |   |
| Restructuring  charges                               |       | —                               |       | 614                                 |       | — |   | 498 |   |
| Amortization of  intangibles                         |       | 593                                  |       | 895                                 |       | 1,973 |   | 2,295 |   |
| Stock-based  compensation                            |       | 270                                  |       | 309                                 |       | 868 |   | 927 |   |
| Total operating  expenses                            |       | 9,577                                |       | 12,111                              |       | 33,574 |   | 34,808 |   |
| Income (loss)  from operations                       |       | (7,387                               | )          | 3,410                               |       | (21,963 | ) | 7,597 |   |
| Equity in income  (losses) of affiliates             |       | 41                                   |       | (71                                 | )          | 115 |   | (171 | ) |
| Other income  (expense), net                         |       | 99                                   |       | (55                                 | )          | 6,284 |   | (59 | ) |
| Provision for  income taxes                          |       | (176                                 | )          | (188                                | )          | (1,270 | ) | (495 | ) |
| Net income  (loss)                                   |       | (7,423                               | )          | 3,096                               |       | (16,834 | ) | 6,872 |   |
| Dividends on  redeemable convertible preferred stock |       | 14,924                               |       | —                              |       | 7,123 |   | — |   |
| Net income  (loss) applicable to common stockholders |       | $                                    | 7,501      |                                | $          | 3,096 |   | $ | (9,711 | ) | $ | 6,872 |   |

 

**THREEAND NINE MONTHS ENDED JULY 31, 2004 AND 2003**

 

*Revenue*

 
| ** ** | ** ** | **Three Months Ended July 31,** | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|       |       |                                 |       |   |   |   |   |
| Revenue    |       | $                                    | 11,205,000 |   | (44 | )% | $ | 20,055,000 |   |
|            |            |                                      |            |  |  |  |  |  |  |

 
| ** ** | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------|------------|-------------------------------------|------------|
| ** ** | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|       |       |                                |       |   |   |   |   |
| Revenue    |       | $                                   | 32,734,000 |   | (40 | )% | $ | 54,964,000 |   |
|            |            |                                     |            |  |  |  |  |  |  |

 

Revenuefor the third quarter of fiscal year 2004 decreased by $8,850,000 or 44percent, from the third quarter of fiscal year 2003, and revenue for the firstthree quarters of fiscal year 2004 decreased by $22,230,000 or 40 percent, fromthe first three quarters of fiscal year 2003.

 

36

----

 

These decreases were primarily attributable todecreased revenue from our UNIX products and services as a result ofcompetition from other operating systems, primarily Linux, and minimalSCOsource licensing revenue in the first three quarters of fiscal year 2004compared to SCOsource revenue of $7,280,000 in the third quarter of fiscal year2003 and SCOsource revenue of $15,530,000 in the first three quarters of fiscalyear 2003.

 

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

 
| ** **                | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                      |       |                                 |       |   |   |   |   |
| UNIX revenue              |       | $                                    | 10,527,000 |   | (18 | )% | $ | 12,775,000 |   |
| Percent of total  revenue |       | 94                                   | %          |   |   | 64 | % |
| SCOsource  revenue        |       | 678,000                              |       | (91 | )% | 7,280,000 |   |
| Percent of total  revenue |       | 6                                    | %          |   |   | 36 | % |
|                           |            |                                      |            |  |  |  |  |  |  |

 
| ** **                | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                      |       |                                |       |   |   |   |   |
| UNIX revenue              |       | $                                   | 32,025,000 |   | (19 | )% | $ | 39,434,000 |   |
| Percent of total  revenue |       | 98                                  | %          |   |   | 72 | % |
| SCOsource  revenue        |       | 709,000                             |       | (95 | )% | 15,530,000 |   |
| Percent of total  revenue |       | 2                                   | %          |   |   | 28 | % |
|                           |            |                                     |            |  |  |  |  |  |  |

 

The decrease in revenuein the UNIX business for the third quarter and first three quarters of fiscalyear 2004 compared to the third quarter and first three quarters of fiscal year2003 was primarily attributable to continued competition from other operatingsystems, particularly Linux, as well as a decrease in revenue from corporateaccounts and a decrease from our distribution channel.  We anticipate for the fourth quarter of 2004fiscal year that total UNIX revenue will be consistent with or slightly lowerthan revenue generated in the third quarter of fiscal year 2004.

 

Thedecrease in SCOsource licensing revenue in the third quarter and first threequarters of fiscal year 2004 from the comparable period of the prior fiscalyear was primarily attributable to minimal vendor licensing revenue in the 2004fiscal year periods when compared to $7,280,000 in SCOsource revenue in thethird quarter and $15,530,000 in SCOsource revenue in the first three quartersof fiscal year 2003.  The SCOsourcerevenue generated in the third quarter and first three quarters of fiscal year2003 was from two contracts executed with Sun Microsystems (“Sun”) andMicrosoft Corporation (“Microsoft”).

 

Sales of our UNIXproducts and services during the third quarter and first three quarters offiscal year 2004 were primarily to pre-existing customers.  Our UNIX business revenue dependssignificantly on our ability to market our products to existing customers andto generate upgrades from existing customers. Our UNIX revenue may be lower than currently anticipated if we are notsuccessful with our existing customers or if we lose the support of any of ourexisting hardware and software vendors or our key industry partners withdrawtheir marketing and certification support or direct their support to ourcompetitors.  This may occur as a resultof the decline of our UNIX business and our SCOsource initiatives and inparticular as a result of any lawsuits we have brought against end usersviolating our intellectual property and contractual rights or as a result ofany adverse changes to our UNIX business.

 

37

----

 

*Products Revenue*

 
| ** **                | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                      |       |                                 |       |   |   |   |   |
| Products revenue          |       | $                                    | 8,929,000  |   | (17 | )% | $ | 10,804,000 |   |
| Percent of total  revenue |       | 80                                   | %          |   |   | 54 | % |
|                           |            |                                      |            |  |  |  |  |  |  |

 
| ** **                | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                      |       |                                |       |   |   |   |   |
| Products revenue          |       | $                                   | 27,056,000 |   | (18 | )% | $ | 33,016,000 |   |
| Percent of total  revenue |       | 83                                  | %          |   |   | 60 | % |
|                           |            |                                     |            |  |  |  |  |  |  |

 

Ourproducts revenue consists of software licenses of our UNIX products, primarilyOpenServer and UnixWare, as well as sales of UNIX-related products.  Products revenue includes revenue derivedfrom OEMs, channel and distribution partners and large corporate accounts.  We rely heavily on our two-tier distributionchannel and any disruption in our distribution channel could adversely impactour future products revenue.

 

Thedecrease in products revenue in the third quarter and first three quarters offiscal year 2004 as compared with the third quarter and first three quarters offiscal year 2003 was primarily attributable to decreased sales ofUnixWare and OpenServer products primarily resulting from increased competitionin the operating system market, particularly Linux, and from a decrease ininformation technology spending for UNIX products compared to other operatingsystem products.  This negative impactwas felt in all of our distribution channels, and we believe that thecompetition from Linux will continue in future periods.

 

Our products revenue wasderived primarily from sales of our OpenServer and UnixWare products.  Other products revenue consists mainly ofproduct maintenance and other UNIX-related products.  Revenue for these product lines was asfollows:

 
| ** **                   | ** ** | **Three Months Ended July 31,** | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                         |       |                                 |       |   |   |   |   |
| OpenServer  revenue          |       | $                                    | 4,496,000  |   | (14 | )% | $ | 5,243,000 |   |
| Percent of  products revenue |       | 50                                   | %          |   |   | 49 | % |
| UnixWare revenue             |       | 2,984,000                            |       | (14 | )% | 3,452,000 |   |
| Percent of  products revenue |       | 34                                   | %          |   |   | 32 | % |
| Other products  revenue      |       | 1,449,000                            |       | (31 | )% | 2,109,000 |   |
| Percent of  products revenue |       | 16                                   | %          |   |   | 19 | % |
|                              |            |                                      |            |  |  |  |  |  |  |

 
| ** **                   | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                         |       |                                |       |   |   |   |   |
| OpenServer  revenue          |       | $                                   | 14,278,000 |   | (9 | )% | $ | 15,734,000 |   |
| Percent of  products revenue |       | 53                                  | %          |   |   | 48 | % |
| UnixWare revenue             |       | 8,240,000                           |       | (25 | )% | 10,956,000 |   |
| Percent of  products revenue |       | 30                                  | %          |   |   | 33 | % |
| Other products  revenue      |       | 4,538,000                           |       | (28 | )% | 6,326,000 |   |
| Percent of  products revenue |       | 17                                  | %          |   |   | 19 | % |
|                              |            |                                     |            |  |  |  |  |  |  |

 

Sales of our OpenServerand UnixWare products as well as other products are primarily generated fromexisting customers.  As our existingcustomers have slowed purchasing decisions,

 

38

----

 

decreased purchasing levels or moved to other operating systems,including Linux, our products revenue has declined.

 

*SCOsourceLicensing Revenue*

 
| ** **                   | ** ** | **Three Months Ended July 31,** | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                         |       |                                 |       |   |   |   |   |
| SCOsource  licensing revenue |       | $                                    | 678,000    |   | (91 | )% | $ | 7,280,000 |   |
| Percent of total  revenue    |       | 6                                    | %          |   |   | 36 | % |
|                              |            |                                      |            |  |  |  |  |  |  |

 
| ** **                   | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                         |       |                                |       |   |   |   |   |
| SCOsource  licensing revenue |       | $                                   | 709,000    |   | (95 | )% | $ | 15,530,000 |   |
| Percent of total  revenue    |       | 2                                   | %          |   |   | 28 | % |
|                              |            |                                     |            |  |  |  |  |  |  |

 

SCOsourcelicensing revenue consists of revenue generated from vendor licenses to use ourproprietary UNIX System V code as well as from intellectual propertylicenses.  SCOsource licensing revenuewas $678,000 for third quarter of fiscal year 2004 as compared to $7,280,000 inSCOsource revenue in the third quarter of fiscal year 2003, and SCOsourcerevenue was $709,000 for the first three quarters of fiscal year 2004 ascompared to $15,530,000 in SCOsource revenue for the first three quarters offiscal year 2003.  The SCOsource revenuegenerated in the third quarter and first three quarters of fiscal year 2003 wasfrom two significant contracts executed with Sun and Microsoft.

 

Due to a lack ofhistorical experience and the uncertainties related to our SCOsource licensingrevenue, we are unable to estimate the amount and timing of futurerevenue.  If we do receive revenue fromthis source, it may be sporadic and fluctuate from quarter to quarter or yearto year.  Our SCOsource initiatives areunlikely to produce stable, predictable revenue for the foreseeable future.

 

*Services Revenue*

 
| ** **                | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                      |       |                                 |       |   |   |   |   |
| Services revenue          |       | $                                    | 1,598,000  |   | (19 | )% | $ | 1,971,000 |   |
| Percent of total  revenue |       | 14                                   | %          |   |   | 10 | % |
|                           |            |                                      |            |  |  |  |  |  |  |

 
| ** **                | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                      |       |                                |       |   |   |   |   |
| Services revenue          |       | $                                   | 4,969,000  |   | (23 | )% | $ | 6,418,000 |   |
| Percent of total  revenue |       | 15                                  | %          |   |   | 12 | % |
|                           |            |                                     |            |  |  |  |  |  |  |

 

Servicesrevenue consists primarily of annual and incident support fees, engineeringservices fees, professional services and education fees.  These fees are typically charged and invoicedseparately from UNIX product sales.  Thedecrease in services revenue of $373,000, or 19 percent, in the third quarterof fiscal year 2004 as compared to the third quarter of fiscal year 2003 andthe decrease in services revenue of $1,449,000, or 23 percent, in the firstthree quarters of fiscal year 2004 as compared to the first three quarters offiscal year 2003 was in part due to a decrease in professional services revenueresulting from a decrease in the demand for our custom enterprise-levelprojects as well as from a decrease in our support services, engineeringservices and team services agreements and generally from a decrease in overallUNIX product revenue.

 

39

----

 

Servicesrevenue during the third quarter and first three quarters of fiscal year 2004was generated primarily from pre-existing customers.  Our UNIX business services revenue dependssignificantly on our ability to market our services to existing customers.  Additionally, our future level of services revenue dependson our ability to generate UNIX products revenue from existing customers and onthe renewal of certain annual support and services agreements with existingcustomers.

 

*Cost of Products Revenue*

 
| ** **                     | ** ** | **Three Months Ended July 31,** |       |
|--------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** |   |
|                           |       |                                 |       |   |   |   |   |
| Cost of products revenue       |       | $                                    | 741,000    |   | (38 | )% | $ | 1,200,000 |   |
| Percentage of products revenue |       | 8                                    | %          |   |   | 11 | % |
|                                |            |                                      |            |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Nine Months Ended July 31,** |       |
|--------------------------------|------------|-------------------------------------|------------|
| ** **                     | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** |   |
|                           |       |                                |       |   |   |   |   |
| Cost of products revenue       |       | $                                   | 2,364,000  |   | (31 | )% | $ | 3,422,000 |   |
| Percentage of products revenue |       | 9                                   | %          |   |   | 10 | % |
|                                |            |                                     |            |  |  |  |  |  |  |

 

Cost of products revenue primarily includes overheadcosts, manufacturing costs, royalties to third-party vendors and technologycosts.  Cost of products revenue decreasedby $459,000, or 38 percent, in the third quarter of fiscal year 2004 comparedto the third quarter of fiscal year 2003 and decreased by $1,058,000, or 31percent, in the first three quarters of fiscal year 2004 compared to the firstthree quarters of fiscal year 2003.  Thisdecrease was primarily attributable to reduced product revenue and reducedoverhead and manufacturing costs resulting from our cost reduction efforts.

 

For the fourth quarter of fiscal year 2004, we expectthe dollar amount of our cost of products revenue to be generally consistent toour cost of products revenue incurred in the third quarter of fiscal year 2004.

 

*Cost of SCOsource Licensing Revenue*  

 
| ** **                                | ** ** | **Three Months Ended July 31,** |       |
|-------------------------------------------|------------|--------------------------------------|------------|
| ** **                                | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** |   |
|                                      |       |                                 |       |   |   |   |   |
| Cost of SCOsource licensing revenue       |       | $                                    | 7,396,000  |   | 312 | % | $ | 1,796,000 |   |
| Percentage of SCOsource licensing revenue |       | 1091                                 | %          |   |   | 25 | % |
|                                           |            |                                      |            |  |  |  |  |  |  |

 
| ** **                                | ** ** | **Nine Months Ended July 31,** | ** ** |
|-------------------------------------------|------------|-------------------------------------|------------|
| ** **                                | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                                      |       |                                |       |   |   |   |   |
| Cost of SCOsource licensing revenue       |       | $                                   | 15,486,000 |   | 275 | % | $ | 4,129,000 |   |
| Percentage of SCOsource licensing revenue |       | 2184                                | %          |   |   | 27 | % |
|                                           |            |                                     |            |  |  |  |  |  |  |

 

Cost of SCOsource licensing revenue includes thesalaries and related personnel costs of employees dedicated to the SCOsourcelicensing initiatives, legal and professional fees incurred in connection withour SCOsource initiatives, and an allocation of corporate costs.

 

Cost of SCOsource licensing revenue increasedsignificantly in the third quarter and first three quarters of fiscal year 2004compared to the third quarter and first three quarters of fiscal

 

40

----

 

year2003.  The increased costs in the 2004periods compared to the 2003 periods was primarily attributable to increasedlegal fees incurred in connection with our ongoing litigation with IBM, Novell,AutoZone and DaimlerChrysler as well as our continued pursuit of intellectualproperty licenses.  We expect thatlegal fees will vary from quarter to quarter depending on the level of, andactivity surrounding, our intellectual property claims, and therefore aredifficult to predict.  Additionally, the cost of SCOsource licensingrevenue likely will fluctuate from quarter to quarter due in part to theunpredictability of the related SCOsource revenue.  Although we currently intend to cap our potentiallegal expenses by revising our fee agreement with BSF, as described below,legal expenses could increase over time depending on developments in ourongoing litigation.  Legal expenses mayalso include contingency payments made to BSF and the other law firms engagedby us to protect our intellectual property rights, which at this time we areunable to predict the amount or timing of such contingency fees.  Additionally, we are unable to predict thepercentage of cost of SCOsource licensing revenue for future quarters due tothe unpredictability of the related licensing revenue.

 

On August 31,2004, we announced we had entered into a nonbinding letter of intentwith BSF, to revise the existing fee agreement with BSF to limit our overallfuture cash costs of legal fees, including accrued legal fees as of July 31,2004, associated with our pending intellectual property litigation to a totalof $31,000,000.  In addition, the nonbinding letter of intent contemplatesthat BSF will lead our intellectual property legal efforts through the durationand completion of the pending litigation. In return for the new fee arrangement, the letter of intent providesthat the contingency fee payable to BSF and other law firms associated with anysettlement or judgment award will vary on a scaled basis from 20 to 33 percent,depending on the size of the award.  Therevised fee agreement is subject to the Company and BSF entering into adefinitive revised fee agreement.  Thesedevelopments, if completed, will allow us to better predict future cost ofSCOsource licensing revenue.

 

*Cost of Services Revenue*

 
| ** **                     | ** ** | **Three Months Ended July 31,** |       |
|--------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** |   |
|                           |       |                                 |       |   |   |   |   |
| Cost of services revenue       |       | $                                    | 878,000    |   | (43 | )% | $ | 1,538,000 |   |
| Percentage of services revenue |       | 55                                   | %          |   |   | 78 | % |
|                                |            |                                      |            |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------|------------|-------------------------------------|------------|
| ** **                     | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                           |       |                                |       |   |   |   |   |
| Cost of services revenue       |       | $                                   | 3,273,000  |   | (35 | )% | $ | 5,008,000 |   |
| Percentage of services revenue |       | 66                                  | %          |   |   | 78 | % |
|                                |            |                                     |            |  |  |  |  |  |  |

 

Cost of services revenue includes the salaries andrelated personnel costs of employees delivering services revenue as well asthird-party service agreements.  Cost ofservices revenue decreased by $660,000, or 43 percent, for the third quarter offiscal year 2004 compared to the third quarter of fiscal year 2003 anddecreased by $1,735,000, or 35 percent, for the first three quarters of fiscalyear 2004 compared to the first three quarters of fiscal year 2003.  This decrease was attributable in partto lower services revenue, reduced employee and related costs in our supportservices and professional services groups as well as the elimination of certainthird-party support contracts in order to increase the gross margin for thesegroups.

 

For the fourth quarter of fiscal year 2004, we expectthe dollar amount of our cost of services revenue to be lower than our cost ofservices revenue incurred in the third quarter of fiscal year 2004.

 

41

----

 

*Sales and Marketing*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                                 |       |   |   |   |   |
| Sales and marketing expense |       | $                                    | 4,233,000  |   | (29 | )% | $ | 5,930,000 |   |
| Percentage of total revenue |       | 38                                   | %          |   |   | 30 | % |
|                             |            |                                      |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                                |       |   |   |   |   |
| Sales and marketing expense |       | $                                   | 13,952,000 |   | (24 | )% | $ | 18,421,000 |   |
| Percentage of total revenue |       | 43                                  | %          |   |   | 34 | % |
|                             |            |                                     |            |  |  |  |  |  |  |

 

Sales and marketing expenses consist of the salaries,commissions and other personnel costs of employees involved in the revenuegeneration process, as well as advertising and corporate allocations.  The decrease in sales and marketing expensesfrom the third quarter of fiscal year 2003 to the third quarter of fiscal year2004 of $1,697,000, or 29 percent, and the decrease in sales and marketingexpense from the first three quarters of fiscal year 2003 to the first threequarters of fiscal year 2004 of $4,469,000, or 24 percent, was primarily attributableto reductions in sales and marketing employees, reduced travel expenses, andlower commissions.  Our sales and marketing expenses as apercentage of total revenue were higher in the fiscal year 2004 periodscompared to the fiscal year 2003 periods primarily as a result of lower totalrevenue in the 2004 periods.  Oursales and marketing headcount decreased from 124 as of July 31, 2003, to72 as of July 31, 2004.

 

For the fourth quarter of fiscal year 2004, weanticipate the dollar amount of sales and marketing expenses will decreasecompared to the third quarter of fiscal year 2004.

 

*Research and Development*

 
| ** **                       | ** ** | **Three Months Ended July 31,** | ** ** |
|----------------------------------|------------|--------------------------------------|------------|
| ** **                       | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                             |       |                                 |       |   |   |   |   |
| Research and development expense |       | $                                    | 2,592,000  |   | (12 | )% | $ | 2,950,000 |   |
| Percentage of total revenue      |       | 23                                   | %          |   |   | 15 | % |
|                                  |            |                                      |            |  |  |  |  |  |  |

 
| ** **                       | ** ** | **Nine Months Ended July 31,** | ** ** |
|----------------------------------|------------|-------------------------------------|------------|
| ** **                       | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                             |       |                                |       |   |   |   |   |
| Research and development expense |       | $                                   | 8,167,000  |   | 0 | % | $ | 8,142,000 |   |
| Percentage of total revenue      |       | 25                                  | %          |   |   | 15 | % |
|                                  |            |                                     |            |  |  |  |  |  |  |

 

Research and development expenses consist of thesalaries and benefits of software engineers, consulting expenses as well ascorporate allocations.  The decrease inresearch and development expense in the third quarter of fiscal year 2004 of $358,000,or 12 percent, compared to the third quarter of fiscal year 2003 was primarilyattributable to reductions in research and development employees and relatedemployee costs.  Research and developmentexpenses for the first three quarters of fiscal year 2004 compared to the firstthree quarters of fiscal year 2003 were flat. Our research and development expenses as a percentage of total revenuewere higher in the fiscal year 2004 periods compared to the fiscal year 2003periods primarily as a result of lower total revenue in the 2004 periods.  Our research and development personneldecreased from 84 as of July 31, 2003, to 75 as of July 31, 2004.

 

42

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For the fourth quarter of fiscal year 2004, we anticipatethe dollar amount of research and development expenses will decrease comparedto the third quarter of fiscal year 2004 due to recently implemented costreductions.

 

*General and Administrative*

 
| ** **                         | ** ** | **Three Months Ended July 31,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                               |       |                                 |       |   |   |   |   |
| General and administrative expense |       | $                                    | 1,889,000  |   | 34 | % | $ | 1,413,000 |   |
| Percentage of total revenue        |       | 17                                   | %          |   |   | 7 | % |
|                                    |            |                                      |            |  |  |  |  |  |  |

 
| ** **                         | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                               |       |                                |       |   |   |   |   |
| General and administrative expense |       | $                                   | 6,475,000  |   | 43 | % | $ | 4,525,000 |   |
| Percentage of total revenue        |       | 20                                  | %          |   |   | 8 | % |
|                                    |            |                                     |            |  |  |  |  |  |  |

 

General and administrative expenses consist of thesalaries and benefits of finance, human resources and executive management andexpenses for external professional services as well as corporateallocations.  Included in general andadministrative expense for the first three quarters of fiscal year 2004 are$682,000 in payments made in connection with the elimination of approximately16 percent of our workforce which occurred during the second quarter of fiscal year2004.

 

The increase in general and administrative expensefrom the third quarter and first three quarters of fiscal year 2003 of $476,000and $1,950,000, respectively, compared to the third quarter and first threequarters of fiscal year 2004, exclusive of the above mentioned terminationpayments, was attributable to increased legal costs as a result of corporateand regulatory legal matters and increased fees from other non-legalprofessional service providers, even though our general and administrativeheadcount decreased from 52 as of July 31, 2003 to 41 as of July 31,2004.  Our general and administrativeexpenses as a percentage of total revenue were higher in the fiscal year 2004periods compared to the fiscal year 2003 periods in part due to lower totalrevenue in the 2004 periods.

 

For the fourth quarter of fiscal year 2004, weanticipate the dollar amount of general and administrative expenses will beconsistent with the third quarter of fiscal year 2004.

 

*Restructuring Charges*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                                 |       |   |   |   |   |
| Restructuring charges       |       | $                                    | —     |   | n/a |   | $ | 614,000 |   |
| Percentage of total revenue |       | 0                                    | %          |   |   | 3 | % |
|                             |            |                                      |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                                |       |   |   |   |   |
| Restructuring charges       |       | $                                   | —     |   | n/a |   | $ | 498,000 |   |
| Percentage of total revenue |       | 0                                   | %          |   |   | 1 | % |
|                             |            |                                     |            |  |  |  |  |  |  |

 

We didnot incur any restructuring charges during the third quarter or first threequarters of fiscal year 2004.  During thethird quarter of fiscal year 2003, the Company incurred a restructuring chargeof $614,000 in connection with the termination of employment for certainpositions.  The restructuring charge of$498,000 for the first three quarters of fiscal year 2003 was

 

43

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comprised of the actiondescribed above for the third quarter of fiscal year 2003, the closing of theCompany’s UK subsidiary, offset by adjustments to previously recorded accruals.

 

During the fourth quarter of fiscal year 2004, weplan to take additional cost reduction actions, which will include reductionsin staff as well as certain reductions and consolidation in office space, whichwill further decrease our operating costs. We estimate that the restructure costs associated with these actions maybe approximately $2,000,000, but the actual costs associated with these actionsmay differ from this estimate.

 

*Amortization of Intangibles*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                                 |       |   |   |   |   |
| Amortization of intangibles |       | $                                    | 593,000    |   | (34 | )% | $ | 895,000 |   |
| Percentage of total revenue |       | 5                                    | %          |   |   | 4 | % |
|                             |            |                                      |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                                |       |   |   |   |   |
| Amortization of intangibles |       | $                                   | 1,973,000  |   | (14 | )% | $ | 2,295,000 |   |
| Percentage of total revenue |       | 6                                   | %          |   |   | 4 | % |
|                             |            |                                     |            |  |  |  |  |  |  |

 

Amortization ofintangibles is the expensing of previously recorded amounts for assets recordedin prior acquisitions with finite lives. The decrease in amortization of intangibles of $302,000 for the thirdquarter of fiscal year 2004 compared to the third quarter of fiscal year 2003and the decrease of $322,000 for the first three quarters of fiscal year 2004compared to the first three quarters of fiscal year 2003 was primarilyattributable to reduced amortization expense recorded on certain assets andtechnology acquired from The Santa Cruz Operation (now Tarantella, Inc.).

 

*Losson Impairment of Long-lived Assets*

 

We didnot have any impairment charges during the third quarter of fiscal year2004.  However, we recorded a loss onimpairment of long-lived assets totaling $2,139,000 for the first threequarters of fiscal year 2004.  Theimpairment related to goodwill and intangible assets acquired in connectionwith our acquisition of Vultus in June 2003.  We concluded that an impairment triggeringevent occurred as an impending partnership that would solidify the Vultusrevenue and cash flow opportunities did not materialize.  Consequently, we have concluded that nosignificant future cash flows related to our Vultus assets will berealized.  We performed an impairmentanalysis of our recorded goodwill related to the Vultus reporting unit inaccordance with SFAS No. 142. Additionally, an impairment analysis of the intangible assets wasperformed in accordance with SFAS No. 144. As a result of these analyses, we wrote-down the carrying value of ourgoodwill related to our Vultus acquisition from $1,166,000 to $0, andwrote-down the intangible assets related to our Vultus acquisition from$973,000 to $0.  We did not incur anyimpairment charges in the third quarter or first three quarters of fiscal year2003.

 

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*Stock-basedCompensation*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2004**                             | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                                 |       |   |   |   |   |
| Stock-based compensation    |       | $                                    | 270,000    |   | (13 | )% | $ | 309,000 |   |
| Percentage of total revenue |       | 2                                    | %          |   |   | 2 | % |
|                             |            |                                      |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2004**                            | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                                |       |   |   |   |   |
| Stock-based compensation    |       | $                                   | 868,000    |   | (6 | )% | $ | 927,000 |   |
| Percentage of total revenue |       | 3                                   | %          |   |   | 2 | % |
|                             |            |                                     |            |  |  |  |  |  |  |

 

Stock-basedcompensation consisted of the following components for the three and ninemonths ended July 31, 2004 and 2003 (in thousands):

 
| ** **                               | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                               | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                     |       |                                 |       |                                |       |   |   |   |   |
| Amortization of stock-based compensation |       | $                                    | 51         |                                | $          | 235 |   | $ | 274 |   | $ | 631 |   |
| Options and shares for services          |       | 219                                  |       | 74                                  |       | 502 |   | 296 |   |
| Modifications to options                 |       | —                               |       | —                              |       | 92 |   | — |   |
| Total                                    |       | $                                    | 270        |                                | $          | 309 |   | $ | 868 |   | $ | 927 |   |
|                                          |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |

 

*Equity inIncome (Losses) of Affiliates*

 

Weaccount for our ownership interests in companies that we own at least 20percent and less than 50 percent using the equity method of accounting.  Under the equity method, we record ourportion of the entities’ net income or net loss in our condensed consolidatedstatements of operations.  During thethird quarter and first three quarters of fiscal year 2004 we recorded incomeof $41,000 and $115,000, respectively, primarily related to income from ourjoint venture in China compared to a loss of $71,000 and $171,000,respectively, in the third quarter and first three quarters of fiscal year 2003primarily related to our investment in Vista, Inc. (“Vista”).  We disposed of our investment in Vista infiscal year 2003.

 

*OtherIncome (Expense), net*

 

Otherincome (expense) consisted of the following components for the three and ninemonths ended July 31, 2004 and 2003 (in thousands):

 

| ** **                         | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Interest income                    |       | $                                    | 186        |                                | $          | 42 |   | $ | 698 |   | $ | 92 |   |
| Interest expense                   |       | —                               |       | (3                                  | )          | — |   | (3 | ) |
| Change in fair value of derivative |       | —                               |       | —                              |       | 5,924 |   | — |   |
| Other expense, net                 |       | (87                                  | )          | (94                                 | )          | (338 | ) | (148 | ) |
| Total other income (expense), net  |       | $                                    | 99         |                                | $          | (55 | ) | $ | 6,284 |   | $ | (59 | ) |

 

Interestincome increased by $144,000 for the third quarter of fiscal year 2004 comparedto the third quarter of fiscal year 2003 and increased by $606,000 for the firstthree quarters of fiscal year 2004 compared to the first three quarters offiscal year 2003 as a result of interest earned on higher cash balances.  The income recorded for the first threequarters of fiscal year

 

45

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2004 of $5,924,000 on thechange in fair value of the derivative related to the decreasing fair value ofthis instrument and marking it to market at each balance sheet date.  The derivative financial instrument was eliminatedduring the second quarter of fiscal year 2004.

 

*Provision for Income Taxes*

 

The provision for income taxes was $176,000 in thethird quarter of fiscal year 2004 and $188,000 in the third quarter of fiscalyear 2003 and $1,270,000 for the first three quarters of fiscal year 2004 and$495,000 for the first three quarters of fiscal year 2003.  Theincrease in the provision for income taxes for the first three quarters offiscal year 2004 compared to the first three quarters of fiscal year 2003 wasprimarily attributable to accruals for withholding taxes that are estimated tobe paid in connection with the operations of the Indian branch of our UnitedKingdom subsidiary, The SCO Group, Ltd.

 

*DividendsRelated to Redeemable Convertible Preferred Stock*

 

* *In connection with completingthe February 5, 2004 exchange of Series A-1 shares for Series A shares, weremoved the carrying value of the Series A shares and related derivative andrecorded the fair value of the Series A-1 shares issued in the exchangetransaction.  The difference betweenthese two amounts was $6,305,000 and was recorded as a non-cash dividend forthe first three quarters of fiscal year 2004.

 

Withthe completion of the repurchase transaction with BayStar during the thirdquarter of fiscal year 2004, we will not be required to continue to accrue orpay any dividends on the Series A-1 shares, which are now retired and no longerissued and outstanding.  As a result ofcompleting the repurchase transaction with BayStar, we recorded a capitalcontribution in the amount of $15,475,000, which represented the difference inthe carrying value of the Series A-1 shares and accrued dividends less the fairvalue of the 2,105,263 shares of common stock and the $13,000,000 in cash.  We had no dividends accrued or payable in thethird quarter or first three quarters of fiscal year 2003.

 

If the repurchase had not occurred, dividends on theSeries A-1 shares would have been paid after October 16, 2004, the firstanniversary of the original Series A private placement, quarterly at a rate of8 percent per annum, subject to annual increases of 2 percent per annum, not toexceed 12 percent per annum.  Although weaccrued dividends of $551,000 for the third quarter of fiscal year 2004 and$2,047,000 for the first three quarters of fiscal year 2004, which reducedearnings to common stockholders, we will no longer accrue dividends onpreferred stock because the repurchase transaction with BayStar closed.  We never paid any dividends on the Series A orSeries A-1 shares.

 

The following table details the components of thedividends (in thousands):

 

| ** **                                        | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                        | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                              |       |                                 |       |                                |       |   |   |   |   |
| Accrual of dividends on preferred stock           |       | $                                    | (551       | )                                   | $          | — |   | $ | (2,047 | ) | $ | — |   |
| Exchange of Series A shares for Series A-1 shares |       | —                               |       | —                              |       | (6,305 | ) | — |   |
| Repurchase of Series A-1 shares from BayStar      |       | 15,475                               |       | —                              |       | 15,475 |   | — |   |
| Total                                             |       | $                                    | 14,924     |                                | $          | — |   | $ | 7,123 |   | $ | — |   |

 

**Liquidityand Capital Resources**

 

Ourcash and equivalents and available-for-sale securities balances decreased from$68,523,000 as of October 31, 2003 to $43,027,000 as of July 31, 2004and our working capital decreased from $37,168,000 as of October 31, 2003to $20,374,000 as of July 31, 2004. Our cash and

 

46

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equivalents decreasedfrom $64,428,000 as of October 31, 2003 to $5,582,000 as of July 31,2004, primarily as a result of purchases of available-for-sale securities, cashdenoted as restricted cash to fund the BayStar stock repurchase and from cashused in operations.

 

Duringfiscal year 2003, we completed a private placement of 50,000 Series A sharesfor net proceeds of $47,740,000 in October 2003, which shares wereexchanged for Series A-1 shares in February 2004 and which in turn we repurchasedfrom BayStar in July 2004.  Becausewe repurchased the outstanding Series A-1 shares, the net proceeds received inour private placement are reduced by the $13,000,000 cash component of therepurchase price.  We intend to use thenet proceeds from our preferred stock financing as well as our other cashresources to pursue our SCOsource initiatives and fund other cash needs of ourbusiness.  During the first threequarters of fiscal year 2004, we used $10,703,000 of cash in ouroperations.  We believe that we will havesufficient cash resources to fund our current operations for at least the next12 months.

 

Ournet cash used in operations for the first three quarters of fiscal year 2004was $10,703,000 compared to cash generated from operations of $6,776,000 forthe first three quarters of fiscal year 2003. Cash used in operations in the first three quarters of fiscal year 2004included a net loss of $16,834,000, non-cash expenses of $180,000 and changesin operating assets and liabilities of $6,311,000.

 

Our net accounts receivable balance decreased by$3,328,000 from $9,282,000 as of October 31, 2003 to $5,954,000 as of July 31,2004.  This decrease was primarilyattributable to the collection of year-end receivables and lower invoicingduring the third quarter of fiscal year 2004. The majority of our accounts receivable are current and our allowancefor doubtful accounts was approximately $126,000 as of July 31, 2004,which represented approximately 2 percent of our gross accounts receivablebalance.  This allowance as a percentageof gross accounts receivable is consistent with our experience in priorperiods, and we expect this trend to continue. Our write-offs of uncollectible accounts during the third quarter offiscal year 2004 were not significant. Our current liabilities decreased from $45,112,000 as of October 31,2003 to $44,579,000 as of July 31, 2004 primarily related to theelimination of the fair-value of the derivative related to our now retiredSeries A shares and the decrease in accrued compensation to law firms, whichwere offset by an increase in accrued liabilities and an increase in thepayable to BayStar in connection with the Series A-1 repurchase transaction.

 

Ourinvesting activities have historically consisted of equipment purchases,investing in strategic partners and the purchase and sale of available-for-salesecurities.  During the first threequarters of fiscal year 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 andcash used to acquire the outstanding minority interest in our Japanesesubsidiary of $209,000.  Cash used ininvesting activities was $1,474,000 for the first three quarters of fiscal year2003 and was attributable to equipment purchases of $524,000 and an investmentin non-marketable securities of $950,000.

 

Ourfinancing activities used $14,224,000 during the first three quarters of fiscalyear 2004 and consisted primarily of $13,000,000 in cash reserved to fund therepurchase of Series A-1 shares from BayStar, cash used to purchase shares ofour common stock on the open market of $2,414,000 and cash used in the exchangeof Series A-1 for Series A shares of $211,000. These uses of cash were offset from proceeds received from the exerciseof stock options of $591,000 and proceeds from the purchase of shares of commonstock by our employees through our employee stock purchase program of$810,000.  Cash provided by financingactivities was $2,329,000 for the first three quarters of fiscal year 2003 andwas attributable to proceeds received from the exercise of stock options of$1,443,000, the exercise of a warrant for $650,000 and proceeds from the

 

47

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purchase of shares of common stock byour employees through our employee stock purchase program of $236,000.

 

During fiscal year 2003 and fiscal year 2004, we haveexpanded our efforts with the law firms representing us in connection with ourpursuit of our intellectual property claims and we currently expect to devotesubstantially more financial resources to this effort.  In addition to paying fees at reduced hourlyrates to these firms, our agreement with the law firms provides that we willpay the law firms a contingency fee of 20 percent of the proceeds fromspecified events related to the protection of our intellectual property rights.

 

As explained above in this Item 2 under the caption “RecentDevelopments,” we have entered into a nonbinding letter ofintent with BSF, our outside litigation legal counsel, to revise the existingfee agreement with BSF.  Upon completingthe revised agreement, we expect we will limit our future cash costs of legalfees, including accrued legal fees to BSF as of July 31, 2004, associatedwith our pending intellectual property litigation to a total of$31,000,000.  In addition, the nonbinding letter of intent provides thatthe contingency fee payable to BSF and other law firms associated with anysettlement or judgment award, which is currently set at 20 percent, will varyon a scaled basis from 20 to 33 percent, depending on the size of theaward.  Events that may trigger acontingency fee may include settlements, judgments, certain licensing fees,subject to certain exceptions, and a sale of our company during the pendancy oflitigation or through settlement, subject to agreed upon credits for amountsreceived as discounted hourly fees and unused retainer fees.  Additionally, our current agreement with thelaw firms may also be construed to include contingency fee payments inconnection with our issuance of equity securities, although we currentlyanticipate eliminating this contingency in the contemplated revised feeagreement.

 

We expect that legal fees will vary from quarter toquarter depending on the level of, and activity surrounding, our intellectualproperty claims, and therefore such costs are difficult to predict.  Additionally, although we intend to cap our potential legalexpenses by revising our fee agreement with BSF, legal expenses couldincrease over time depending on developments in litigation involving us, andcertain events outside of our control could occur or certain contingent eventscould take place that would require us to pay additional fees to the lawfirms.  To the extent that our SCOsourcerelated costs and legal fees exceed our budgeted amounts, or SCOsource revenueis below our expectations, our liquidity will be adversely impacted and fewerfinancial resources will be available for other initiatives such as maintainingand enhancing our UNIX business. Additionally, future contingency fees payable to the law firms may besignificant in future periods, which may have an adverse impact on ourliquidity.  Our current fee arrangementwith our law firms could also impair our ability to raise equity capital infuture periods.  If we are not able toenter into a definitive revised fee agreement with BSF that effectively limitsthe cash payments we may be required to make to pursue our claims, ourliquidity will be adversely impacted.

 

We have entered into operating leases for ourcorporate offices located in the United States and our international salesoffices.  We have commitments under theseleases that extend through fiscal year 2010. In prior corporate restructuring actions, we partially vacated some ofthese facilities, but still have contractual obligations to continue to makeongoing lease payments for one facility that will use available cash.  We have pursued and will continue to pursuesublease opportunities, as available, to minimize this use of cash; however, wemay not be successful in eliminating or reducing cash expenditures for thisfacility.

 

48

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The following table summarizes our contractual leaseobligations as of July 31, 2004:  

 

| ** **                  | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1 - 3 years** | ** ** | **More than  3 years** | ** ** |
|-----------------------------|------------|-----------|------------|-----------------------|------------|-----------------|------------|------------------------|------------|
|                        |       |      |       |                  |       |            |       |                   |       |
| Operating lease obligations |       | $         | 5,826,000  |                  | $          | 2,389,000       |       | $                      | 2,844,000  |   | $ | 593,000 |   |
|                             |            |           |            |                       |            |                 |            |                        |            |  |  |  |  |

 

As of July 31, 2004, we did not have anylong-term debt obligations, purchase obligations or material capital leaseobligations.

 

During fiscal year 2004, we have undertaken certaincost-cutting measures to reduce our overall operating costs.  These cost-cutting measures have focused onstreamlining operations and job functions where possible, and have impacted alloperating departments within the Company. Even though we have undertaken these measures, our ability in the futureto cut costs to offset revenue declines in our UNIX business is limited to acertain extent because of contractual commitments to maintain and support ourexisting UNIX customers.  The decline inour UNIX business may be accelerated if industry partners withdraw theirsupport as a result of declines in our UNIX business or our SCOsourceinitiatives and in particular any lawsuits against end users violating ourintellectual property and contractual rights. The decline in our UNIX business and our SCOsource initiatives,particularly lawsuits against such end users, may cause industry partners,developers and hardware and software vendors to choose not to support orcertify to our UNIX operating system products. This may lead to an accelerated decline in our UNIX products andservices revenue.  If our UNIX productsand services revenue is less than expected, our liquidity will be adverselyimpacted.

 

In the event that cash required to fund operations andstrategic initiatives exceeds our current cash resources and cash generatedfrom operations, we will be required to reduce costs and perhaps raiseadditional capital.  We may not be ableto reduce costs in a manner that does not impair our ability to maintain ourUNIX business and pursue our SCOsource initiatives.  We may also not be able to raise capital forany number of reasons including those listed under the section ”RiskFactors” below.  If additional equityfinancing is available, it may not be available to us on attractive terms andmay be dilutive to our existing stockholders. In addition, if our stock price declines, we may not be able to accessthe public equity markets on acceptable terms, if at all.  Our ability to effect acquisitions for stockwould also be impaired.

 

As discussed elsewhereabove in Part I, Item 1 of this Amendment No. 1 to Form 10-Q/A, weissued shares and granted options under the Plans without complying withregistration or qualification requirements under federal securities laws andthe securities laws of certain states. As a result, certain Plan participants have a right to rescind theirpurchases of shares under the Plans or recover damages if they no longer ownthe shares or hold unexercised options, subject to applicable statutes oflimitations, and we may make a rescission offer to certain of such Planparticipants subject to obtaining required regulatory approvals.  Additionally, regulatory authorities mayrequire us to pay fines or they may impose other sanctions on us, and we mayface other claims by Plan participants other than rescission claims.

 

If our potential rescission offer is made and acceptedby Plan participants holding shares acquired under the Plans or otherwiseentitled to recover damages from us in respect of such shares they have sold,or such Plan participants otherwise make rescission claims against us, we couldbe liable to make aggregate payments to these Plan participants of up to$557,000 in the aggregate, excluding interest and other possible fees, basedupon shares outstanding under the Plans as of July 31, 2004.

 

49

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We may also face additional rescission liability toPlan participants holding unexercised stock options in California, Georgia andpossibly other states.  Regulatoryauthorities may require us to pay fines or impose other sanctions on us.  Although we believe that it is reasonablypossible that some Plan participants holding unexercised options may accept arescission offer or potentially attempt to enforce a rescission right, we areunable to estimate the number of participants who might pursue rescission orthe potential rescission liability we may have to them.  Since any loss is considered reasonablypossible but not estimable, we have not recorded a liability for thiscontingency.

 

We mayalso be required to pay interest and penalties up to statutory limits inconnection with Plan participants making rescission claims or in connectionwith any rescission offer.  We believethat it is reasonably possible that we may be required to pay interest andpenalties, but are not able to estimate an amount.

 

On March 10,2004, our board of directors authorized management, in its discretion, topurchase up to 1,500,000 shares of our common stock over a 24-monthperiod.  Shares may be purchased in openmarket transactions, block purchases or privately negotiated transactions.  Any repurchased shares will be held astreasury stock and will be available for general corporate purposes. During the second quarter of fiscal year 2004, a total of 290,000 sharesof our common stock were repurchased for a total of $2,414,000.  We did not purchase any shares during thethird quarter of fiscal year 2004. However, if we repurchase a substantial number of shares during this24-month period, and we do not generate off-setting revenue form our UNIX andSCOsource businesses, our cash position could decrease significantly and ourability to fund future operations could be adversely impacted.  Purchases under the stock repurchase programare subject to the discretion of management based on market conditions and otherfactors including the trading price of our common stock, availability of stock,alternative uses of capital and our financial condition.

 

**RecentAccounting Pronouncements**

 

TheEmerging Issues Task Force has issued EITF 03-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments.”  The issue addressed in EITF 03-1 is todetermine the meaning of other-than-temporary impairment and its application todebt and equity securities.  The TaskForce reached a consensus that the application guidance in EITF 03-1 should beused to determine when an investment is considered impaired, whether thatimpairment is other than temporary, and the measurement of an impairmentloss.  The guidance also includesaccounting considerations subsequent to the recognition of other-than-temporaryimpairment and requires certain disclosures about unrealized losses that havenot been recognized as other-than-temporary impairments.  The recognition and measurement guidanceshould be applied to other-than-temporary impairment evaluations in reportingperiods beginning after June 15, 2004, or our fourth fiscal quarter of2004.  The adoption of thisinterpretation is not expected to have a material effect on our business,results of operations, financial position, or liquidity.

 

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

 

*Foreign Currency Risk. *We have foreign offices andoperations in Europe and Asia.  As aresult, a portion of our revenue is derived from sales to customers outside theUnited States.  Most of thisinternational revenue is denominated in U.S. dollars.  However, most of the operating expensesrelated to our foreign-based operations are denominated in foreign currenciesand therefore operating results are affected by changes in the U.S. dollarexchange rate in relation to foreign currencies such as the Euro, amongothers.  If the U.S. dollar weakenscompared to the Euro, our operating expenses for foreign operations will behigher when translated back into U.S.

 

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dollars.  Our revenue can also be affected by generaleconomic conditions in the United States, Europe and other internationalmarkets.  Our results of operations maybe affected in the short term by fluctuations in foreign currency exchangerates.

 

We have in the past utilized foreign currency forwardexchange contracts for market exposures of underlying assets andliabilities.  We do not use forwardexchange contracts for speculative or trading purposes.  Our accounting policies for foreign exchangecontracts are based on our designation of each contract.  The criteria we use for designating eachcontract include the contracts’ effectiveness in risk reduction and one-to-onematching of forward exchange contracts to underlying assets andliabilities.  Gains and losses oncurrency forward contracts that are firm commitments are deferred andrecognized in income in the same period that the underlying transactions aresettled.  Gains and losses on currencyforward contracts that are designated and effective for existing transactionsare recognized in income in the same period as losses and gains on theunderlying transactions are recognized and generally offset.  Gains and losses on any instruments notmeeting the above criteria are recognized in income in the current period.  As of July 31, 2004, we had nooutstanding instruments classified as hedges.

 

*Interest Rate Risk. *The primary objective of our cash management strategyis to invest available funds in a manner that assures maximum safety andliquidity and maximizes yield within such constraints.  We do not borrow money for short-terminvestment purposes.

 

*Investment Risk. *We have invested in equity instruments of privatelyheld and public companies in the technology industry for business and strategicpurposes.  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 to regularly review the assumptions andoperating performance of these companies and to record impairment losses whenevents and circumstances indicate that these investments may be impaired.  As of July 31, 2004, our investmentsbalance was approximately $565,000 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 extreme pricefluctuations.  In addition, factors suchas new product introductions by our competitors or developments in thelitigation related to our SCOsource initiatives may have a significant impacton the market price of our common stock. Furthermore, quarter-to-quarter fluctuations in our results ofoperations caused by changes in customer demand may have a significant impacton the market price of our common stock. These conditions could cause the price of our common stock to fluctuatesubstantially over short periods of time.

 

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

 

Under the supervision and with the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, we evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e)under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based upon that evaluation, and subsequentevaluations, the Chief Executive Officer and Chief Financial Officer concludedthat, as of the end of the period covered by this report and as a result of thematerial weakness in our internal controls described below, our disclosurecontrols and procedures were noteffective to ensure that information required to be disclosed by us in thereports we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in applicable rulesand forms.

 

 We have a materialweakness with respect to accounting for capital stock and stock optiontransactions.  We have issued certainshares of our common stock under our equity

 

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compensationplans without complying with the registration requirements of federal andapplicable state securities laws.  As aresult, the holders of such shares may have a rescission right, and,consequently, certain amounts the Company received upon purchase of such sharesmust be reclassified from permanent equity to temporary equity.  We reclassified from permanent equity totemporary equity $557,000 related to certain shares of common stock issuedunder the Company’s equity compensation plans that are subject torescission.  We determined that we lackedprocedures to reconcile shares issued with shares available under registrationstatements in a timely manner.

 

In addition, we incorrectly accounted for dividends onSeries A Convertible Preferred Stock by not recording dividends payable as of January 31,2004 and April 30, 2004.  We alsoincorrectly accounted for compensation expense by not properly accounting for anon-routine stock option grant to a non-employee.  Neither of the above mentioned mattersimpacted the financial statements as of and for the three and nine months endedJuly 31, 2004.  We determined thatwe lacked resources with proper experience to review the Company’s accountingfor capital stock and stock option transactions.

 

Our internal controls over financial reporting did notidentify the preceding error prior to the completion of the financialstatements and the filing of the Form 10-Q for such period.  We have discussed these matters with theAudit Committee of the Board of Directors and with KPMG LLP, our independentauditors.  In response, we haveimplemented in our internal control procedures additional detail transactionalcontrols, an equity compliance checklist and additional review and approvalprocedures.

 

During the quarter covered by this quarterly report,there has been no change in our internal control over financial reporting (asdefined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting. However, as discussed above, changes have been implemented subsequent tothe end of the quarter covered by this quarterly report to add additionalcontrols to correct the material weakness in internal control over financialreporting.

 

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

 

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

#### *** ***

•                              Our continued investmentin and commitment to our UNIX operating systems, including investing inresearch and development efforts during fiscal year 2004 to enhance ourOpenServer and UnixWare, which enhancements we believe will help prolong ourUNIX revenue stream for future quarters;`

 

•                              Our estimation that the decline in our UNIX business revenue may beaccelerated if industry partners withdraw their support as a result of ourdeclining UNIX business and our SCOsource initiatives and in particular anylawsuits against end users violating our intellectual property and contractualrights;

 

•                              Our belief that thefuture success of our SCOsource initiatives will depend on our ability toprotect our intellectual property;

 

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•                              Our expectation thatquarterly legal fees and other SCOsource related costs will vary from quarterto quarter depending upon the level of, and activity surrounding, ourintellectual property claims, and therefore are difficult to predict;

 

•                              Our anticipation that wewill enter into a revised fee agreement with BSF as contemplated in ournonbinding letter of intent that will limit the future cash costs of legalfees, including accrued legal fees to BSF as of July 31, 2004, associatedwith our pending intellectual property litigation to a total of $31,000,000,confirm that BSF will lead our intellectual property legal efforts through theduration and completion of our pending litigation, provide that the contingencyfee payable to BSF and other law firms associated with any settlement orjudgment award will vary on a scaled basis from 20 to 33 percent, dependingupon the size of the award, and eliminate the right of our law firms to receiveany contingency fee payment in connection with any issuance of equitysecurities;

 

•                              Our expectation that,although we intend to cap our potential legal expenses by revising our feeagreement with BSF, our legal expenses could increase depending on developmentsin our litigation, and, even if we do revise our fee agreement with BSF, theoccurrence of certain events outside our control or certain contingent eventscould require us to pay additional fees to our law firms;

 

•                              Our intention to continueseeking to enter into license agreements with UNIX vendors and offeringSCOsource IP licenses to Linux end users;

 

•                              Our anticipation that forthe fourth quarter of fiscal year 2004 our UNIX revenue will be consistent withor slightly lower than revenue generated in the third quarter of fiscal year2004;

 

•                              Our expectation that ourUNIX business will continue to be impacted by competition from Linux;

 

•                              Our expectation that during the fourth quarter of fiscal year 2004, wewill take additional cost reduction actions, which will include reductions instaff as well as certain reductions and consolidation in office space, whichwill further decrease the operating costs of our UNIX business.  We estimate that the restructure costassociated with these actions may be approximately $2,000,000, but the actualcost associated with these actions may differ from this estimate;

 

•                              Our expectation that ourfuture level of services revenue depends in part on our ability to generateUNIX products revenue from existing customers as well as renew certain annualsupport and services agreements with existing UNIX customers;

 

•                              Our expectation for thefourth quarter of fiscal year 2004 that our cost of products revenue in dollarswill be consistent with our cost of products revenue incurred in the thirdquarter of fiscal year 2004;

 

•                              Our expectation for thefourth quarter of fiscal year 2004 that our cost of services revenue in dollarswill be lower than in the third quarter of fiscal year 2004;

 

•                              Our expectation for thefourth quarter of fiscal year 2004 that our sales and marketing expenses indollars will decrease from our expenses incurred in the third quarter of fiscalyear 2004;

 

•                              Our expectation for thefourth quarter of fiscal year 2004 that our research and development expensesin dollars will decrease from our expenses incurred in the third quarter offiscal year 2004 due to recently implemented cost reductions;

 

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•                              Our expectation for thefourth quarter of fiscal year 2004 that our general and administrative expensesin dollars will be consistent with our general and administrative expensesincurred in the third quarter of fiscal year 2004;

 

•                              Our belief that the IndiaIncome Tax Department probably will pursue tax assessments on revenue for taxableperiods subsequent to March 2001 deemed by such tax authority to beroyalty revenue of our UK subsidiary, The SCO Group, Ltd.;

 

•                              Our intention to use thenet proceeds from our preferred stock financing as well as our other cashresources to pursue our SCOsource initiatives and fund other cash needs of ourbusiness;

 

•                              Our belief that we havesufficient cash resources to fund our current operations for at least the next12 months;

 

•                              Our belief that ourallowance for bad debts will remain consistent with our prior experience; and

 

•                              Our belief that certainlegal actions to which we are a party will not have a material adverse effecton us.

 

We wish to caution readers that our operating resultsare subject to various risks and uncertainties that could cause our actualresults and outcomes to differ materially from those discussed or anticipated,including the success of our SCOsource initiatives, competition from otheroperating systems, particularly Linux, the amount and timing of SCOsourcelicensing revenue, our ability to enhance our UNIX operating systems andmaintain our UNIX products and services business, and the factors set forth inthe subsection entitled “Risk Factors” below.  We also wish to advise readers not to placeany undue reliance on the forward-looking statements contained in this report,which reflect our beliefs and expectations only as of the date of thisreport.  We assume no obligation toupdate or revise these forward-looking statements to reflect new events orcircumstances or any changes in our beliefs or expectations, other than asrequired by law.

 

#### ***Risk Factors***

 

*Wedo not have a history of profitable operations.*

 

Our fiscal year ended October 31, 2003 was thefirst full year we were profitable in our operating history.  Our profitability in fiscal year 2003resulted primarily from our SCOsource licensing initiatives.  For the nine months ended July 31, 2004,we incurred a net loss from operations of $21,963,000 and our accumulateddeficit as of July 31, 2004 was $217,700,000.  If we do not receive SCOsource licensingrevenue in future quarters and our revenue from the sale of our UNIX productsand services continues to decline, we will need to further reduce operatingexpenses to generate positive cash flow. We may not be able to further reduce operating expenses without damagingour ability to support our existing UNIX business.  Additionally, we may not be able to achieveprofitability through additional cost-cutting actions.

 

Our UNIX products and services revenue has declined ineach of the last four years primarilyas a result of increased competition from alternative operating systems,particularly Linux, lower information technology spending for UNIX products,and a general overall decline in economic conditions.  In our quarterly results of operations, werecognize revenue from agreements for support and maintenance contracts andother long-term contracts that have been previously invoiced and are includedin deferred revenue.  While our deferredrevenue balance increased from $5,501,000 as of October 31, 2003 to$5,936,000 as of July 31, 2004, our deferred revenue balance had declinedprior to this period and this recent modest increase in deferred revenue maynot continue into future quarters, which may have a negative impact on our UNIX

 

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revenue.  Ourfuture UNIX revenue may be adversely impacted and may continue to decline if weare unable to replenish these deferred revenue balances with long-termmaintenance and support contracts or replace them with other sustainablerevenue streams.  If we are unable togenerate positive cash flow and profitable operations, our operations may beadversely impacted.

 

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*Ourfuture SCOsource licensing revenue is uncertain.*

 

We initiated the SCOsource licensing effort in January 2003to review the status of UNIX licensing and sublicensing agreements.  This effort resulted in the execution of twosignificant vendor license agreements during fiscal year 2003 and generated$25,846,000 in revenue.  During the threeand nine months ended July 31, 2004, we recorded SCOsource licensingrevenue of $678,000 and $709,000, respectively, related to the execution ofintellectual property compliance licenses. Due to a lack of historical experience and the uncertainties related toSCOsource licensing revenue, we are unable to estimate the amount and timing offuture SCOsource licensing revenue, if any. If we do receive revenue from this source, it may be sporadic andfluctuate from quarter to quarter.  OurSCOsource initiatives are unlikely to produce stable, predictable revenue forthe 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.

 

*We may not prevail in our legal actions againstIBM, Novell and end users, and unintended consequences of our actions againstIBM, Novell and end users and other initiatives to assert our intellectualproperty rights may adversely affect our business.*

 

Wecontinue to pursue our litigation against IBM. As described in more detail in Item 1 of Part II of this quarterlyreport, we seek damages for claims generally relating to our allegation thatIBM has inappropriately used and distributed our UNIX source code andderivative works in connection with its efforts to promote the Linux operatingsystem.  IBM has responded to our claimsand brought counterclaims against us asserting generally that we do not havethe right to assert claims based on our ownership of UNIX intellectual propertyagainst IBM or others in the Linux community. Discovery is continuing in the case, and several motions are currentlypending before the court.  If we do notprevail in our action against IBM, or if IBM is successful in its counterclaimsagainst us, our business and results of operations could be materially harmedand we may not be able to continue in business. The litigation with IBM andothers will be costly, and our costs for legal fees have been and may continueto be substantial and may exceed our capital resources. Additionally, themarket price of our common stock may be negatively affected as a result ofdevelopments in our legal action against IBM that may be, or may be perceivedto be, adverse to us.

 

Inaddition, we have publicly, and in individual letters, cautioned users of Linuxthat there are unresolved intellectual property issues surrounding Linux thatmay expose them to unanticipated liability to us.  We have also notified a large number oflicensees under our UNIX contracts requiring them to, among other things, certifythey are in compliance with their agreements, including that they are not usingour proprietary UNIX code in Linux, have not allowed unauthorized use oflicensed UNIX code by their employees or contractors and have not breachedconfidentiality provisions relating to licensed UNIX code.  As a result of our action against IBM and ourother SCOsource initiatives to protect our intellectual property rights,several participants in the Linux industry and others affiliated with IBM orsympathetic to the Linux movement have taken actions attempting to negativelyaffect our business and our SCOsource efforts. Linux proponents have taken abroad range of actions against us, including, for example, attempting toinfluence participants in the markets in which we sell our products to reduceor eliminate the amount of our products and services they purchase from us. Weexpect that similar efforts likely will continue. There is a risk thatparticipants in our marketplace will negatively view our action against IBM,DaimlerChrysler and AutoZone and our other SCOsource initiatives, and we maylose support from such participants.  Anyof the foregoing could adversely affect our position in the marketplace, ourresults of operations and our stock price and our ability to stay inbusiness.   We have also experiencedseveral denial-of-service attacks on our website, which have prevented webusers from accessing our website and doing business with us for a period oftime. If such attacks continue or if

 

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our customers andstrategic partners are also subjected to similar attacks, our business andresults of operations could be materially harmed.

 

Also,some of the more significant participants in the Linux industry have madeefforts to ease Linux end users’ concerns that their use of Linux may subjectthem to potential copyright infringement claims from us. For example, Hewlett-Packard,Novell and Red Hat have each established indemnification programs for qualifiedcustomers purchasing Linux-based products and services that may potentiallybecome subject to copyright infringement claims from us. Additionally, OpenSource Development Labs, a non-profit organization (“OSDL”), has established alegal defense fund that will be used to defend Linux users against copyrightinfringement lawsuits brought by us. It has been reported that OSDL so far hasattracted several million dollars in pledges from contributors including IBMand Intel among others. Similarly, Red Hat, Inc. has announced it hascommitted one million dollars for a separate fund it created to cover the legalexpenses of other companies developing Linux.

 

As afurther response to our SCOsource initiatives and claim that our UNIX sourcecode and derivative works have inappropriately been included in Linux, Novellhas publicly asserted its belief that it owns certain copyrights in our UNIXsource code, and it has filed 15 copyright applications with the United StatesCopyright Office related to UNIX.  Novellalso claims that it has a license to UNIX from us and the right to authorizeits customers to use UNIX technology in their internal businessoperations.  Specifically, Novell hasalso claimed to have retained rights related to legacy UNIX SVRx licenses,including the license with IBM.  Novellasserts it has the right to take action on behalf of SCO in connection withsuch licenses, including termination rights. Novell has purported to veto our termination of the IBM, Sequent and SGIlicenses. We have repeatedly 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 all suchassets and rights from Novell in September 1995 pursuant to an assetpurchase agreement, as amended.  In January 2004,in response to Novell’s actions, we brought suit against Novell for slander oftitle seeking relief for Novell’s alleged bad faith effort to interfere withour copyrights related to our UNIX source code and derivative works and ourUnixWare products.  Our lawsuit againstNovell is also described in more detail in Item 1 of Part II of this quarterlyreport.

 

Notwithstandingour assertions of full ownership of UNIX-related intellectual property rights,as set forth above, including copyrights, and even if we are successful in ourlegal action against Novell and end users such as AutoZone and DaimlerChrysler,the efforts of Novell and the other Linux proponents described above may causeLinux end users to be less willing to purchase from us our SCOsource IPlicenses authorizing their use of our intellectual property contained in theLinux operating system, which may adversely affect our revenue from ourSCOsource initiatives.  These efforts ofLinux proponents also may increase the negative view some participants in ourmarketplace have regarding our legal actions against IBM, Novell and end userssuch as AutoZone and DaimlerChrysler and regarding our SCOsource initiativesand may contribute to creating confusion in the marketplace about the validityof our claim that the unauthorized use of our UNIX source code and derivativeworks in Linux infringes on our copyrights. Increased negative perception and potential confusion about our claimsin our marketplace could impede our continued pursuit of our SCOsourceinitiatives and negatively impact our business. Additionally, if we fail in ourlawsuit against Novell and end users such as AutoZone and DaimlerChrysler, thenegative perception and confusion in our marketplace about our intellectualproperty rights and claims likely would increase significantly, and theeffectiveness of our SCOsource initiatives could be materially harmed.

 

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

 

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Thedecline in our UNIX business and our SCOsource initiatives, particularlylawsuits against end users violating our intellectual property and contractualrights, may cause industry partners, developers and hardware and softwarevendors to choose not to support or certify to our UNIX operating systemproducts.  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 seeks adeclaratory judgment for non-infringement of copyrights and no misappropriationof trade secrets.  In addition, Red Hatclaims we have engaged in false advertising in violation of the Lanham Act,deceptive trade practices, unfair competition, tortious interference withprospective business opportunities, and trade libel and disparagement.  We intend to vigorously defend this action,but if Red Hat is successful in its claim against us, our business and resultsof operations could be materially harmed.

 

Inaddition, other regulators or others in the Linux community have initiated orin the future may initiate legal actions against us, all of which maynegatively impact our operations or 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 quarterly operating results or our failure to meet the expectations ofanalysts or investors, even in the short-term, could cause our stock price todecline significantly. Because of the potential for significant fluctuations inour SCOsource licensing revenue in any particular period, you should not relyon quarter-to-quarter comparisons of our results of operations as an indicationof future performance.

 

Factorsthat may affect our results include:

 

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

 

•                              the interest level ofresellers in recommending our UNIX business solutions to end users;

 

•                              the introduction,development, timing, competitive pricing and market acceptance of our productsand services and those of our competitors;

 

•                              changes in generaleconomic conditions, such as recessions, that could affect capital expendituresand recruiting efforts in the software industry;

 

•                              results of, ordevelopments in, our ongoing litigation with IBM, Novell, Red Hat, AutoZone andDaimlerChrysler concerning our UNIX intellectual property;

 

•                              changes in businessattitudes toward UNIX as a viable operating system compared to other competingsystems, especially Linux;

 

•                              the contingency and otherlegal fees we may pay to the law firms representing us in our efforts toestablish our intellectual property rights; and

 

•                              changes in attitudes ofcustomers and partners due to the decline in our UNIX business and ouraggressive position against the inclusion of our UNIX code and derivative worksin Linux and our lawsuits against end users violating our intellectual propertyand contractual rights.

 

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

 

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.

 

*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 the relationshipsthrough which resellers, solution providers or equipment integrators purchaseour products.  In turn, we do not controlthe presentation 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.

 

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

 

Ourrevenue from the sale of UNIX products has declined over the last four years.This decrease in revenue has been attributable primarily to increasedcompetition from other operating systems, particularly Linux and lowerinformation technology spending for UNIX products. Our sales of UNIX productsand services are primarily to existing customers.  If the demand for UNIX products continues todecline, and we are unable to develop UNIX products and services thatsuccessfully address a market demand, our UNIX revenue will continue todecline, industry participants may not certify to our operating system and products,we may not be able to attract new customers or retain existing customers andour business and results of operations will be adversely affected.  Because of the long adoption cycle foroperating system purchases and the long sales cycle of our operating systemproducts, we may not be able to reverse these revenue declines quickly.

 

*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 theUNIX operating system market, our competitors include IBM, Hewlett-Packard,Sun, Microsoft and other Linux distributors. These and other competitors are aggressively pursuing the current UNIXoperating system market.  Many of thesecompetitors have access to substantially greater resources than we do.  The major competitive alternatives to ourUNIX products are Microsoft Windows Server, Linux and other UNIX systems.  The expansion of Microsoft’s and our othercompetitors’ offerings may restrict the overall market available for our serverproducts, including some markets where we have been successful in the past.

 

Ourfuture success may depend in part on our ability to continue to meet theincreasing needs of our customers by supporting existing and emergingtechnologies.  If we do not enhance ourproducts to meet these evolving needs, we may not remain competitive and beable to grow our business.  Additionally,because technological advancement in the UNIX operating system market

 

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and alternative operatingsystem markets is progressing at an advanced pace, we will have to develop andintroduce enhancements to our existing products and any new products on atimely basis to keep pace with these developments, evolving industry standardsand changing customer requirements. Our failure to meet any of these and othercompetitive pressures may render our existing products and services obsolete,which would have an adverse impact on our revenue and operations.

 

Thesuccess of our UNIX business will depend on the level of commitment andcertification we receive from industry partners and developers.  In recent years, we have seen hardware andsoftware vendors as well as software developers turn their certification andapplication development efforts toward Linux and elect not to continue tosupport or certify to our UNIX operating system products.  If this trend continues, our competitiveposition will be adversely impacted and our future revenue from our UNIXbusiness will decline.  The decline inour UNIX business may be accelerated if industry partners withdraw their supportfrom us for any reason including as a result of our SCOsource initiatives andin particular any lawsuit against end users violating our intellectual propertyand contractual rights, such as our lawsuits against AutoZone andDaimlerChrysler.

 

*Ourcompensation arrangement with the law firms representing us to enforce ourintellectual property rights may reduce our ability to raise additionalfinancing.*

 

Ourcompensation arrangement with the law firms representing us in our efforts toestablish our intellectual property rights could inhibit our ability to raiseadditional funding if needed.  Inaddition to receiving fees at reduced hourly rates, our agreement with the lawfirms provides that the law firms will receive a contingency fee of20 percent of the proceeds from specified events related to the protectionof our intellectual property rights, and, if we reach a revised fee agreementwith the law firms as currently contemplated in the nonbinding letter of intentwe have entered into with BSF, such contingency fee may reach 33 percent ofsuch proceeds.  Events triggering acontingency fee may include settlements, judgments, certain licensing fees,subject to certain exceptions, and a sale of our company during the pendancy oflitigation or through settlement, subject to agreed upon credits for amountsreceived as discounted hourly fees and unused retainer fees.  Our current agreement with the law firms mayalso be construed to include contingency fee payments in connection withissuances of our equity securities. Future payments payable to the law firmsunder this arrangement may be significant. Our law firms’ right to receive suchcontingent payments could cause prospective investors to choose not to investin our company or limit the price at which new investors would be willing toprovide additional funds to our company. We may be unable to reach a definitive revised fee agreement with BSFthat reflects the terms of the nonbinding letter of intent as describedelsewhere in this filing.

 

*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 foreign operations are subject tocertain inherent risks, including:

 

•                              potential loss ofdeveloped technology through piracy, misappropriation, or more lenient lawsregarding intellectual property protection;

 

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

 

•                              fluctuations in currencyexchange rates and economic instability;

 

•                              longer payment cycles forsales in foreign countries;

 

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•                              seasonal reductions inbusiness activity; and

 

•                              political unrest,particularly in areas where we have facilities.

 

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 may leadto 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 second quarter of fiscal year 2004, the Indian branch of our UK subsidiarywas given a withholding tax assessment from the Government of India Income TaxDepartment.  The Tax Department assesseda 15 percent withholding tax on certain revenue transactions in India that theTax Department deemed royalty revenue under the Income Tax Act.  We have filed an appeal with the TaxDepartment and believe that our packaged software does not qualify for “royalties”treatment and therefore would not be subject to withholding tax.  However, we may be unsuccessful in our appealagainst the Tax Department and be obligated to pay the assessed taxableamounts.  If other countries in which wehave international operations, such as India, continue to develop and beginenforcing their tax regimes, 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.  Competition for qualified professionals inthe software industry is intense, and departures of existing personnel could bedisruptive to our business and can result in the departure of otheremployees.  The loss or departure of anyofficers or key employees could harm our ability to implement our business planand could adversely affect our operations. Our future success depends to a significant extent on the continuedservice and coordination of our management team, particularly Darl C. McBride,our President and Chief Executive Officer. We do not maintain key person insurance for any member of our managementteam.

 

*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 $3.89 on September 13, 2004. The share price haschanged dramatically over short periods with increases and decreases of over 25percent in a single day.  We believe thatthe changes in our stock price are affected by changing public perceptionsconcerning the strength of our intellectual property claims and other factorsbeyond our control.  Public perceptioncan change quickly and without any change or development in our underlyingbusiness or litigation position.  Aninvestment in our stock is subject to such volatility and, consequently, issubject to significant risk.

 

*Risksassociated with the potential exercise of our options outstanding.*

 

As of September 1,2004, we have issued and outstanding options to purchase up to approximately3,478,000 shares of common stock with exercise prices ranging from $0.76 to$28.00 per share.  The existence of suchrights to acquire common stock at fixed prices may prove a hindrance to ourefforts to raise future equity and debt funding, and the exercise of suchrights will dilute the percentage ownership interest of our stockholders andmay dilute the value of their

 

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ownership.  The possible future sale of shares issuableon the exercise of outstanding options could adversely affect the prevailingmarket price for our common stock. Further, the holders of the outstanding rights may exercise them at atime when we would otherwise be able to obtain additional equity capital onterms 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.*

 

Wehave an effective registration statement relating to the sale or distributionby BayStar and Royal Bank of Canada, an initial investor in our private placement of Series A shares (“RBC”) as sellingstockholders of up to 3,703,704 shares of common stock that were issuable uponconversion of our previously outstanding Series A-1 shares, although the onlyshares of common stock issued pursuant to the conversion of Series A-1 sharesthat may be sold or distributed pursuant to this registration statement are740,740 shares issued to RBC. Additionally, we have an effective registration statement 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.  With respect to either of theseregistration statements, we will not receive any proceeds from the sales of theshares they cover.  The shares that maybe sold or distributed pursuant to these registration statements representapproximately 12.1 percent of our issued and outstanding common stock as of September 1,2004.

 

Thesale of the block of stock covered by the registration statement, or even thepossibility of its sale, may adversely affect the trading market for our commonstock and reduce the price available in that market.  The shares of common stock subject to ourregistration statements will, upon issuance, dilute the equity ownershippercentage of the holders of our common stock.

 

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

 

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

 

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

 

Ourboard of directors currently has the right, with respect to the 5,000,000shares of our preferred stock, to authorize the issuance of one or moreadditional series of our preferred stock with such voting, dividend and otherrights as our directors determine.  Theboard of directors can designate new series of preferred stock without theapproval of the holders of our common stock. The rights of holders of ourcommon stock may be adversely affected by the rights of any holders ofadditional shares of preferred stock that may be issued in the future,including without limitation, further dilution of the equity ownershippercentage of our holders of common stock and their voting power if we issuepreferred stock with voting rights. Additionally, the issuance of preferredstock could make it more difficult for a third party to acquire a majority ofour outstanding voting stock.

 

*OurStockholder Rights Plan could make it more difficult for a hostile bid for theCompany or a change of control transaction to succeed at current market pricesfor our stock.*

 

Wehave adopted a Stockholder Rights Plan (“Rights Plan”) as described elsewherein this filing.  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 the Board of Directors.

 

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*We may have issued shares andoptions under the Plans that were not exempt from registration or qualificationunder federal and state securities laws, and, as a result, we may incurliability to repurchase such shares and options and may face additionalpotential claims under federal and state securities laws.*

 

Webelieve we have issued certain shares and granted options under the Plans (aspreviously defined in Part I, Item 1 of this Amendment No. 1 to Form 10-Q/A)without complying with registration or qualification requirements under federalsecurities laws and the securities laws of certain states.  As a result, certain Plan participants thathave acquired shares issued under the Plans have rescission rights against us,subject to applicable statutes of limitations, and we may, subject to obtainingrequired regulatory approvals, make a rescission offer to certain of such Planparticipants.  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 ourpotential rescission offer is made and accepted by Plan participants holdingshares acquired under the Plans or otherwise entitled to recover damages fromus in respect of such shares they have sold, or such Plan participantsotherwise make rescission claims against us, we could be liable to makeaggregate payments to these Plan participants of up to $557,000 in theaggregate, excluding interest and other possible fees, based upon sharesoutstanding under the Plans as of July 31, 2004.

 

We mayface additional rescission liability to Plan participants holding unexercisedstock options in California, Georgia and possibly other states and for sharesissued in violation of federal and state securities laws.  Additionally, federal securities laws do notprovide that a rescission offer will terminate a purchaser’s right to rescind asale of stock that was not registered as required, and our possible rescissionoffer may not terminate a purchaser’s right to rescind a sale of stock that wasnot registered as required under federal laws. If we do not make the planned rescission offer to all plan participants,or any or all of the offerees reject the rescission offer, we may continue tobe liable under federal and state securities laws.

 

**PART II.****                                                OTHERINFORMATION**

 

**ITEM 1.****                                                     LEGALPROCEEDINGS**

 

*IBMCorporation*

 

On orabout March 6, 2003, we filed a complaint against IBM.  This action is currently pending in theUnited States District Court for the District of Utah, under the title *The SCO Group, Inc. vs. International BusinessMachines Corporation*, Civil No. 2:03CV0294.  The initial complaint included claims forbreach of contract, misappropriation of trade secrets, tortious interference,and unfair competition.  The initialcomplaint also alleged that IBM obtained information concerning the UNIX sourcecode and derivative works from us and inappropriately used and distributed thatinformation in connection with its efforts to promote the Linux operatingsystem.  As a result of IBM’s actions, weare requesting damages in an amount to be proven at trial, together withadditional damages through and after the time of trial.  On or about June 13, 2003, we deliveredto IBM a notice of termination of IBM’s UNIX license agreement with us thatunderlies IBM’s AIX software.

 

On orabout June 16, 2003, we filed an amended complaint in the IBM case.  The amended complaint essentially restatedand re-alleged the allegations of the initial complaint and expands on thoseclaims.  Most importantly, the amendedcomplaint raises new allegations regarding IBM’s actions and breaches throughthe actions of Sequent Computer Systems, Inc. (“Sequent”), which IBMacquired.  We alleged that our licensingagreement with Sequent was breached in several ways similar to those set forthabove and we seek damages for those breaches. We are also seeking injunctive relief on several claims.

 

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IBMhas filed a response and counterclaim to the complaint, including a demand fora jury trial.  We have filed an answer tothe IBM counterclaim denying the claims and asserting affirmativedefenses.  On February 4, 2004, wefiled a motion for leave to file amended pleadings in the case proposing toamend our complaint against IBM and to modify our affirmative defenses againstIBM’s counterclaims.  On February 25, 2004, the court grantedour motion for leave to amend.  Thesecond amended complaint, which was filed on February 27, 2004, allegesnine causes of action that are similar to those set forth above, adds a newclaim for copyright infringement and removes the claim for misappropriation oftrade secrets.  IBM filed an answer andcounterclaim.  The counterclaim filed byIBM asserts 14 claims against us.  Inits counterclaim, as amended, IBM asserts that we do not have the right toterminate IBM’s UNIX license or assert claims based on our ownership of UNIXintellectual property against IBM or others in the Linux community.  In addition, IBM asserts we have breached theGNU General Public License and have infringed certain patents held by IBM. IBM’scounterclaims include claims for breach of contract, violation of the LanhamAct, unfair competition, intentional interference with prospective economicrelations, unfair and deceptive trade practices, promissory estoppel, copyrightinfringement for a declaratory judgment of non-infringement of copyrights, andpatent infringement.

 

On March 3, 2004,the U.S. Magistrate Judge issued an order addressing certain discovery mattersrelating to both us and IBM.  We havefiled a motion to dismiss IBM’s tenth counterclaim for a declaratory judgmentof non-infringement of copyrights and a motion to amend the scheduling orderand a motion to bifurcate IBM’s patent counterclaims into another action.  We filed, on May 28, 2004, a reply brief inconnection with our motion to amend the scheduling order, in which we set forthdetailed and specific responses to IBM’s claims made in connection with thatmotion.  A hearing for these motions washeld on June 8, 2004 and the court issued its ruling on June 10,2004.

 

The court granted ourmotion to amend the scheduling order, with certain changes.  The amended scheduling order now provides,among other things, that the deadline for completing fact discovery is February 11,2005 (previously August 4, 2004), the deadline for completing expertdiscovery is April 22, 2005 (previously October 22, 2004), and thetrial will begin on November 1, 2005 (previously April 11,2005).  The court also denied the motionto bifurcate the patent counterclaims without prejudice to our right to requestbifurcation again at a later date.  IBMhas also filed a motion for partial summary judgment on its tenth counterclaimfor a declaration of non-infringement of our copyrights.  A hearing regarding our motion to dismiss andIBM’s motion for partial summary judgment on IBM’s tenth counterclaim for adeclaration of non-infringement is currently scheduled for September 15,2004.  We plan to vigorously oppose IBM’smotion.  We have filed various motionsseeking additional discovery from IBM. IBM has filed two additional motions for summary judgment which we willvigorously oppose.  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.

 

*Red Hat, Inc.*

 

On August 4, 2003, Red Hat filed a complaintagainst us. The action is currently pending in the United States District Courtfor the District of Delaware under the case caption *Red Hat, Inc. v. The SCO Group, Inc.*, Civil No 03-772.  Red Hat asserts that the Linux operatingsystem does not infringe our UNIX intellectual property rights and seeks adeclaratory judgment for non-infringement of copyrights and no misappropriationof trade secrets.  In addition, Red Hatclaims we have engaged in false advertising in violation of the Lanham Act,deceptive trade practices, unfair competition, tortious interference withprospective business opportunities, trade libel, and disparagement.

 

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On orabout September 15, 2003, we filed a motion to dismiss the Red Hatcomplaint.  The motion to dismiss assertsthat Red Hat lacks standing and that no case or controversy exists with respectto the claims seeking a declaratory judgment of non-infringement.  The motion to dismiss further asserts thatRed Hat’s claims under the Lanham Act and related state laws are barred by theFirst Amendment to the U.S. Constitution and the common law privilege ofjudicial immunity. On April 6, 2004, the court issued an order denying ourmotion to dismiss; however, the court stayed the case and requested statusreports every 90 days regarding the case against IBM.  Red Hat has filed a motion forreconsideration.  We intend to vigorouslydefend this action.

 

*Novell, Inc.*

 

On January 20, 2004,we filed suit in Utah state court against Novell, Inc. for slander of titleseeking relief for its alleged bad faith effort to interfere with our ownershipof copyrights related to our UNIX source code and derivative works and ourUnixWare product.  The case is currentlypending in the Third Judicial District Court, Salt Lake County, State of Utah,under the caption *The SCO Group, Inc. v.Novell, Inc.*, Case No.040900936.  In the lawsuit, we requestedpreliminary and permanent injunctive relief as well as damages.  Through these claims we seek to requireNovell to assign to us all copyrights that we believe Novell has wrongfullyregistered, prevent Novell from representing any ownership interest in thosecopyrights and require Novell to retract or withdraw all representations it hasmade regarding its purported ownership of those copyrights.

 

Novell also filed a motion to dismiss our complaintclaiming it never transferred the copyrights to The Santa Cruz Operation (nowTarantella, Inc.). We have filed a response to Novell’s motion to dismiss andhave also filed a motion to remand the case back to the state court.  On June 10, 2004, the court issued amemorandum decision and order which denied our motion to remand the case tostate court.  The memorandum decisionalso denied Novell’s motion to dismiss in part on claims of falsity.  However, the court granted Novell’s motion todismiss regarding our allegations of special damages, but granted us 30 daysleave to amend our complaint to plead special damages with morespecificity.  We have filed our amendedcomplaint and Novell has responded with another motion to dismiss claiming thatNovell’s alleged slanderous statements are privileged under the law.  We plan to continue to vigorously pursue ourclaims against Novell.

 

*DaimlerChryslerCorporation*

 

On orabout March 3, 2004, we brought suit against DaimlerChrysler Corporationfor its alleged violations of its UNIX software agreement with us.  Specifically, the lawsuit alleges thatDaimlerChrysler breached its UNIX software agreement with us by failing tocertify by January 31, 2004 its compliance with the UNIX softwareagreement as required by us.  Thelawsuit, filed in Oakland County Circuit Court in the State of Michigan,requests the court to declare that DaimlerChrysler has violated thecertification requirements of its UNIX software agreement, permanently enjoinDaimlerChrysler from further violations of the UNIX software agreement, issue amandatory injunction requiring DaimlerChrysler to remedy the effects of itspast violations of the UNIX software agreement and award us damages in anamount to be determined at trial together with costs, attorneys’ fees and anysuch other or different relief that the Court may deem to be equitable andjust.  On April 15, 2004,DaimlerChrysler filed a motion to dismiss our claims.  DaimlerChrysler’s motion was heard on July 21,2004 and the court granted DaimlerChrysler’s motion as to the substance ofDaimlerChrysler’s certification but denied the motion as to whether the certificationwas timely.  We are currently evaluatingthe matter and any further actions we may take.

 

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*AutoZone,Inc.*

 

On orabout March 2, 2004, we brought suit against AutoZone, Inc. for itsalleged violations of our UNIX copyrights through its use of Linux.  Specifically, the lawsuit alleges thatAutoZone is infringing our UNIX copyrights by, among other things, runningversions of the Linux operating system that contain code, structure, sequenceand/or organization from our proprietary UNIX System V code in violation of ourcopyrights.  The lawsuit filed in U.S.District Court in Nevada requests injunctive relief against AutoZone’s furtheruse or copying of any part of our copyrighted materials and also requestsdamages as a result of AutoZone’s infringement in an amount to be proven attrial.  On April 23, 2004, AutoZonefiled a motion to transfer the case to Tennessee or to stay the case.  On August 6, 2004, the federal court inNevada entered an order granting AutoZone’s motion to stay the case with 90-daystatus reports to the court.  The courtdenied without prejudice AutoZone’s motion for a more definite statement andits motion to transfer the case to Tennessee. The court also is allowing the parties to take limited expediteddiscovery relating to the issue of preliminary injunctive relief requested byus.  We are undertaking this discoveryprocess.

 

*IPO Class Action Matter*

 

We are an issuerdefendant in a series of class action lawsuits, involving over 300 issuers thathave been consolidated under *In re InitialPublic Offering Securities Litigation*, 21 MC 92 (SAS).  The plaintiffs, the issuers and the insurancecompanies have negotiated an agreement to settle the dispute between theplaintiffs and the issuers.  All parties,including the plaintiffs, issuers and insurance companies, have executed thissettlement agreement and the settlement agreement has been submitted to thecourt for approval.  If the settlementagreement is approved by the court, and if no cross-claims, counterclaims orthird party claims are later asserted, this action will be dismissed withrespect to our directors and us.

 

We have notified ourunderwriters and insurance companies of the existence of the claims.  We believe, after consultation with legalcounsel, that the ultimate outcome of this matter will not have a materialadverse effect on our results of operations or financial position.  As of July 31, 2004, we have paid oraccrued the full retention amount of $200,000 under our insurance coverage.

 

*Other Matters*

 

In April 2003, aformer Indian distributor of ours filed a claim in India, requesting summaryjudgment for payment of $1,428,000, and an order that we trade in India onlythrough the distributor and/or to give a security until the claim is paid. Thedistributor claims that we are responsible to repurchase certain softwareproducts and to reimburse the distributor for certain other operatingcosts.  We do not believe that we areresponsible to reimburse the distributor for any operating costs and alsobelieve that the return rights related to any remaining inventory havelapsed.  We have engaged local counselwho has advised us that such claims will likely fail, but that the distributorwill continue to pursue its claims either in the Indian courts or in the U.S.courts.  Discovery has commenced andhearings have been held and are ongoing. We intend to vigorously defend this action.

 

We are a party to certainother legal proceedings arising in the ordinary course of business includinglegal proceedings arising from our SCOsource initiatives.  We believe, after consultation with legalcounsel, that the ultimate outcome of such legal proceedings will not have amaterial adverse effect on our results of operations or financial position.

 

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**ITEM 2.****                                                    ****UNREGISTERED SALES OFEQUITY SECURITIES AND USE OF PROCEEDS**

 

*Unregistered sales of shares pursuant to EquityCompensation Plans*

 

As discussed elsewhere above in Part I, Item 1 of thisAmendment No. 1 to Form 10-Q/A, during the nine months ended July 31, 2004, weissued shares and granted options under the Plans without complying withregistration or qualification requirements under federal securities laws andthe securities laws of certain states. As a result, certain Plan participantshave a right to rescind their purchases of shares under the Plans or recoverdamages if they no longer own the shares or hold unexercised options, subjectto applicable statutes of limitations, and we may make a rescission offer tocertain of such Plan participants subject to obtaining required regulatoryapprovals. Additionally, regulatory authorities may require us to pay fines orthey may impose other sanctions on us, and we may face other claims by Planparticipants other than rescission claims.

 

*Issuance of common shares uponrepurchase of Series A-1 shares.*

 

On May 31, 2004, we entered into an agreement withBayStar to repurchase and retire BayStar’s 40,000 Series A-1 shares.  Terms of the agreement required us to pay toBayStar $13,000,000 in cash and issue 2,105,263 shares of our commonstock.  The repurchase price was payableand issuable upon the effectiveness of a shelf registration statement coveringthe resale of the shares of common stock that would be issued to BayStar uponthe completion of the repurchase.  On July 21,2004, the SEC declared the registration statement on Form S-3 effective, and asof that date, the transaction closed, all Series A-1 shares were cancelled, andwe issued to BayStar 2,105,263 shares of common stock.

 

We issued the unregistered, restricted shares ofcommon stock (with respect to which the resale was registered as of the closingof the repurchase) in reliance on the exemption from registration provided by Section 4(2)of the Securities Act of 1933, as amended.

 

On August 27, 2004, following the completion ofthe Series A-1 repurchase transaction, after which no Series A-1 sharesremained outstanding, we filed a Certificate of Elimination with the Secretaryof State of the State of Delaware.  Thefiling terminated the Certificate of Designation, Preferences and Rights of ourSeries A-1 shares, eliminating the previously designated Series A-1 shares.

 

*Repurchases of our common stock.*

 

On March 10, 2004,our Board of Directors authorized the repurchase of up to 1,500,000 shares ofour common stock in open-market or private transactions.  The plan will remain in effect for a periodof 24 months from the date announced. There were no repurchases of common stock during the three months ended July 31,2004.

 

**ITEM 6.****                                                     EXHIBITS**

 
| 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)).                                      |

 

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| 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   |   | Stock Repurchase Agreement dated as of May 31, 2004  between SCO and BayStar (incorporated by reference to Exhibit 99.1 to SCO’s  Current Report on Form 8-K filed on June 2, 2004 (File No. 000-29911)).                                         |
|   |   |                                                                                                                                                                                                                                                        |
| 31.1   |   | Certification of  Darl C. McBride, President and Chief Executive Officer, pursuant to Rule  13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                      |
|   |   |                                                                                                                                                                                                                                                        |
| 31.2   |   | Certification of  Bert B. 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 B. 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.                                           |

 

**ITEM 7.****                                                     SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| Date: April 1,  2005 | THE SCO GROUP,  INC. |
|---------------------------|----------------------|
|                      |                 |
|                      |                 | By: | /s/   Bert  B. Young |   |
|                      |                 |   | Bert B. Young |
|                      |                 |   | Duly Authorized  Officer and |
|                      |                 |   | Chief Financial  Officer |
|                      |                 |   | (Principal Financial  and |
|                      |                 |   | Accounting  Officer) |

 

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**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                |       | Stock Repurchase Agreement dated as of May 31, 2004  between SCO and BayStar (incorporated by reference to Exhibit 99.1 to SCO’s  Current Report on Form 8-K filed on June 2, 2004 (File No. 000-29911)).                                         |
|                |       |                                                                                                                                                                                                                                                        |
| 31.1                |       | Certification of  Darl C. McBride, President and Chief Executive Officer, pursuant to Rule  13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                      |
|                |       |                                                                                                                                                                                                                                                        |
| 31.2                |       | Certification of  Bert B. 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 B. 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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