**UNITEDSTATES**

 

**SECURITIES AND EXCHANGECOMMISSION**

 

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark one)**

**ý            QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF1934**

 

**Forthe quarterly period ended April 30, 2005**

**OR**

 

**o            TRANSITION REPORT PURSUANT TO SECTION13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition period from                  to                  **

** **

**Commissionfile number 0-29911**

 

**THE SCO GROUP, INC.**

(Exactname of registrant as specified in its charter)

 

 

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

 

**355South 520 West**

**Suite100**

**Lindon,Utah 84042**

(Addressof principal executive offices and zip code)

 

**(801)765-4999**

(Registrant’stelephone number, including area code)

 

Indicate by check mark whether the Registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to filing requirements for the past 90 days.

 

YES ý NO o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

 

YES o NO ý

 

*As of May 27, 2005, there were 17,923,510 shares of theRegistrant’s common stock, $0.001 par value per share, outstanding.*

* *

* *

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**The SCO Group, Inc.**

 

**Table of Contents**

 

 

 
| PART I.  | FINANCIAL  INFORMATION                                                                                                                       |   |
|----------|----------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item  1. | Unaudited  Financial Statements                                                                                                              |   |
|     | Condensed Consolidated Balance Sheets as of April 30,  2005 and October 31, 2004                                                             |   |
|     | Condensed  Consolidated Statements of Operations and Comprehensive Income (Loss) for the  three and six months ended April 30, 2005 and 2004 |   |
|     | Condensed Consolidated Statements of Cash Flows for  the six months ended April 30, 2005 and 2004                                            |   |
|     | Notes  to Condensed Consolidated Financial Statements                                                                                        |   |
| Item 2.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                  |   |
| Item 3.  | Quantitative and Qualitative  Disclosures About Market Risk                                                                                  |   |
| Item 4.  | Controls and Procedures                                                                                                                      |   |
|     | Forward-Looking  Statements                                                                                                                  |   |
|     | Risk  Factors                                                                                                                                |   |
| PART II. | OTHER INFORMATION                                                                                                                            |   |
| Item 1.  | Legal Proceedings                                                                                                                            |   |
| Item 2.  | Changes in Securities and Use of  Proceeds                                                                                                   |   |
| Item 5.  | Other Information                                                                                                                            |   |
| Item 6.  | Exhibits                                                                                                                                     |   |
| Item 7.  | Signatures                                                                                                                                   |   |

 

2

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

** **

**CONSOLIDATED BALANCE SHEETS**

**(in thousands)**

 
| *** ***                                                                                                  | *** *** | **April 30,**   | ** ** | **October 31,** | *** *** |
|---------------------------------------------------------------------------------------------------------------|--------------|-----------------|------------|-----------------|--------------|
| *** ***                                                                                                  | *** *** | **2005**        | ** ** | **2004**        | *** *** |
| *** ***                                                                                                  | *** *** | **(unaudited)** | ** ** | ** **      | *** *** |
| **ASSETS**                                                                                                    | ** **   | ** **      | ** ** | ** **      | ** **   |
|                                                                                                          |         |            |       |            |         |
| CURRENT ASSETS:                                                                                               |         |            |       |            |         |
| Cash and cash equivalents                                                                                     |         | $               | 8,145      |            | $            | 12,693 |   |
| Restricted cash                                                                                               |         | 7,974           |       | 8,283           |         |
| Available-for-sale securities                                                                                 |         | 6,047           |       | 18,756          |         |
| Accounts receivable, net of allowance for doubtful accounts of $149  and $136, respectively                   |         | 6,325           |       | 6,638           |         |
| Other current assets                                                                                          |         | 2,288           |       | 1,870           |         |
| Total current assets                                                                                          |         | 30,779          |       | 48,240          |         |
|                                                                                                          |         |            |       |            |         |
| PROPERTY AND EQUIPMENT:                                                                                       |         |            |       |            |         |
| Computer and office equipment                                                                                 |         | 2,025           |       | 2,991           |         |
| Leasehold improvements                                                                                        |         | 390             |       | 406             |         |
| Furniture and fixtures                                                                                        |         | 29              |       | 103             |         |
|                                                                                                          |         | 2,444           |       | 3,500           |         |
| Less accumulated depreciation and amortization                                                                |         | (1,865          | )          | (2,851          | )            |
| Net property and equipment                                                                                    |         | 579             |       | 649             |         |
|                                                                                                          |         |            |       |            |         |
| OTHER ASSETS:                                                                                                 |         |            |       |            |         |
| Intangibles, net                                                                                              |         | 4,060           |       | 5,413           |         |
| Other assets                                                                                                  |         | 1,134           |       | 1,098           |         |
| Total other assets                                                                                            |         | 5,194           |       | 6,511           |         |
|                                                                                                          |         |            |       |            |         |
| Total assets                                                                                                  |         | $               | 36,552     |            | $            | 55,400 |   |
|                                                                                                          |         |            |       |            |         |
| **LIABILITIES AND STOCKHOLDERS'  EQUITY**                                                                     | ** **   | ** **      | ** ** | ** **      | ** **   |
|                                                                                                          |         |            |       |            |         |
| CURRENT LIABILITIES:                                                                                          |         |            |       |            |         |
| Accounts payable                                                                                              |         | $               | 1,424      |            | $            | 7,854 |   |
| Payable to Novell, Inc.                                                                                       |         | 4,007           |       | 3,283           |         |
| Accrued compensation to law firms                                                                             |         | —          |       | 7,956           |         |
| Accrued payroll and benefits                                                                                  |         | 2,761           |       | 3,369           |         |
| Accrued liabilties                                                                                            |         | 3,606           |       | 3,855           |         |
| Deferred revenue                                                                                              |         | 4,896           |       | 4,877           |         |
| Other royalties payable                                                                                       |         | 309             |       | 354             |         |
| Taxes payable                                                                                                 |         | 1,287           |       | 1,279           |         |
| Total current liabilities                                                                                     |         | 18,290          |       | 32,827          |         |
|                                                                                                          |         |            |       |            |         |
| LONG-TERM LIABILITIES                                                                                         |         | 342             |       | 343             |         |
|                                                                                                          |         |            |       |            |         |
| COMMITMENTS AND CONTINGENCIES (Note 5)                                                                        |         |            |       |            |         |
|                                                                                                          |         |            |       |            |         |
| COMMON STOCK SUBJECT TO RESCISSION (Note 6)                                                                   |         | 851             |       | 528             |         |
|                                                                                                          |         |            |       |            |         |
| STOCKHOLDERS' EQUITY:                                                                                         |         |            |       |            |         |
| Common stock, $0.001 par value; 45,000 shares authorized, 18,208 and  17,956 shares outstanding, respectively |         | 18              |       | 18              |         |
| Additional paid-in capital                                                                                    |         | 246,528         |       | 246,273         |         |
| Common stock held in treasury; 290 shares, respectively                                                       |         | (2,414          | )          | (2,414          | )            |
| Warrants outstanding                                                                                          |         | 1,099           |       | 1,099           |         |
| Deferred compensation                                                                                         |         | —          |       | (22             | )            |
| Accumulated other comprehensive income                                                                        |         | 977             |       | 964             |         |
| Accumulated deficit                                                                                           |         | (229,139        | )          | (224,216        | )            |
| Total stockholders' equity                                                                                    |         | 17,069          |       | 21,702          |         |
|                                                                                                          |         |            |       |            |         |
| Total liabilities and stockholders' equity                                                                    |         | $               | 36,552     |            | $            | 55,400 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

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

** **

**CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVELOSS**

** (in thousands, exceptper share data)**

** **

 
| ** **                                                                                                   | ** ** | **Three  Months Ended April 30,** | ** ** | **Six  Months Ended April 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                   | ** ** | **2005**                          | ** ** | **2004**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                   | ** ** | **(unaudited)**                   | ** ** | **(unaudited)**                 | ** ** |
| REVENUE:                                                                                                     |       |                              |       |                            |       |   |   |   |   |
| Products                                                                                                     |       | $                                 | 7,838      |                            | $          | 8,415 |   | $ | 15,142 |   | $ | 18,127 |   |
| SCOsource  licensing                                                                                         |       | 30                                |       | 11                              |       | 100 |   | 31 |   |
| Services                                                                                                     |       | 1,390                             |       | 1,711                           |       | 2,881 |   | 3,371 |   |
| Total revenue                                                                                                |       | 9,258                             |       | 10,137                          |       | 18,123 |   | 21,529 |   |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| COST OF REVENUE:                                                                                             |       |                              |       |                            |       |   |   |   |   |
| Products                                                                                                     |       | 563                               |       | 818                             |       | 1,207 |   | 1,623 |   |
| SCOsource  licensing (inclusive of amortization of intangibles of $84, $83, $167, and  $166, respectively)   |       | 2,889                             |       | 4,567                           |       | 6,382 |   | 8,090 |   |
| Services                                                                                                     |       | 746                               |       | 1,073                           |       | 1,495 |   | 2,395 |   |
| Total cost of  revenue                                                                                       |       | 4,198                             |       | 6,458                           |       | 9,084 |   | 12,108 |   |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| GROSS MARGIN                                                                                                 |       | 5,060                             |       | 3,679                           |       | 9,039 |   | 9,421 |   |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| OPERATING  EXPENSES:                                                                                         |       |                              |       |                            |       |   |   |   |   |
| Sales and  marketing (exclusive of stock-based compensation of $7, $29, $14, and $47,  respectively)         |       | 2,963                             |       | 4,698                           |       | 5,900 |   | 9,719 |   |
| Research and  development (exclusive of stock-based compensation of $0, $12, $8, and $23,  respectively)     |       | 2,117                             |       | 2,868                           |       | 4,197 |   | 5,575 |   |
| General and  administrative (exclusive of stock-based compensation of $0, $122, $0, and  $528, respectively) |       | 2,036                             |       | 1,710                           |       | 3,799 |   | 3,904 |   |
| Loss on impairment  of long-lived assets                                                                     |       | —                            |       | 2,139                           |       | — |   | 2,139 |   |
| Severance and  exit costs                                                                                    |       | —                            |       | 682                             |       | — |   | 682 |   |
| Amortization of  intangibles                                                                                 |       | 593                               |       | 593                             |       | 1,186 |   | 1,380 |   |
| Stock-based  compensation                                                                                    |       | 7                                 |       | 163                             |       | 22 |   | 598 |   |
| Total operating  expenses                                                                                    |       | 7,716                             |       | 12,853                          |       | 15,104 |   | 23,997 |   |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| LOSS FROM  OPERATIONS                                                                                        |       | (2,656                            | )          | (9,174                          | )          | (6,065 | ) | (14,576 | ) |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| EQUITY IN INCOME  OF AFFILIATE                                                                               |       | 17                                |       | 37                              |       | 70 |   | 74 |   |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                                                                                     |       |                              |       |                            |       |   |   |   |   |
| Interest income                                                                                              |       | 98                                |       | 242                             |       | 135 |   | 512 |   |
| Change in fair  value of derivative                                                                          |       | —                            |       | 2,300                           |       | — |   | 5,924 |   |
| Other income  (expense), net                                                                                 |       | 702                               |       | (120                            | )          | 1,174 |   | (251 | ) |
| Total other  income (expense), net                                                                           |       | 800                               |       | 2,422                           |       | 1,309 |   | 6,185 |   |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| LOSS BEFORE  INCOME TAXES                                                                                    |       | (1,839                            | )          | (6,715                          | )          | (4,686 | ) | (8,317 | ) |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| PROVISION FOR  INCOME TAXES                                                                                  |       | (123                              | )          | (966                            | )          | (237 | ) | (1,094 | ) |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| NET LOSS                                                                                                     |       | (1,962                            | )          | (7,681                          | )          | (4,923 | ) | (9,411 | ) |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| DIVIDENDS ON  REDEEMABLE CONVERTIBLE PREFERRED STOCK                                                         |       | —                            |       | (7,045                          | )          | — |   | (7,801 | ) |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| NET LOSS APPLICABLE  TO COMMON STOCKHOLDERS                                                                  |       | $                                 | (1,962     | )                               | $          | (14,726 | ) | $ | (4,923 | ) | $ | (17,212 | ) |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| BASIC AND  DILUTED NET LOSS PER COMMON SHARE                                                                 |       | $                                 | (0.11      | )                               | $          | (1.04 | ) | $ | (0.28 | ) | $ | (1.23 | ) |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| WEIGHTED AVERAGE  BASIC AND DILUTED COMMON SHARES OUTSTANDING                                                |       | 17,913                            |       | 14,100                          |       | 17,831 |   | 13,960 |   |
|                                                                                                         |       |                              |       |                            |       |   |   |   |   |
| OTHER  COMPREHENSIVE LOSS                                                                                    |       |                              |       |                            |       |   |   |   |   |
| Net loss                                                                                                     |       | $                                 | (1,962     | )                               | $          | (7,681 | ) | $ | (4,923 | ) | $ | (9,411 | ) |
| Unrealized gain  (loss) on available-for-sale securities                                                     |       | 12                                |       | (99                             | )          | 9 |   | (118 | ) |
| Foreign currency  translation adjustment                                                                     |       | (58                               | )          | 138                             |       | 4 |   | 148 |   |
| COMPREHENSIVE  LOSS                                                                                          |       | $                                 | (2,008     | )                               | $          | (7,642 | ) | $ | (4,910 | ) | $ | (9,381 | ) |

 

Seeaccompanying notes to consolidated financial statements.

 

4

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

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

** **
| *** ***                                                                 | *** *** | **Six Months Ended April 30,** | *** *** |
|------------------------------------------------------------------------------|--------------|--------------------------------|--------------|
| *** ***                                                                 | *** *** | **2005**                       | ** **   | **2004** | *** *** |
| *** ***                                                                 | *** *** | **(unaudited)**                | *** *** |
| * *                                                                     | * *     | * *                       | * *     | * * | * * |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        |         |                           |         |   |   |
| Net loss                                                                     |         | $                              | (4,923       | ) | $ | (9,411 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |         |                           |         |   |   |
| Amortization of intangibles                                                  |         | 1,353                          |         | 1,546 |   |
| Depreciation and amortization                                                |         | 184                            |         | 435 |   |
| Stock-based compensation                                                     |         | 22                             |         | 598 |   |
| Loss on impairment of long-lived assets                                      |         | 32                             |         | 2,139 |   |
| Equity in income of affiliates                                               |         | (70                            | )            | (74 | ) |
| Change in fair value of derivative                                           |         | —                         |         | (5,924 | ) |
| Changes in operating assets and liabilities:                                 |         |                           |         |   |   |
| Restricted cash                                                              |         | 1,033                          |         | — |   |
| Accounts receivable, net                                                     |         | 313                            |         | 2,471 |   |
| Other current assets                                                         |         | (418                           | )            | (81 | ) |
| Other assets                                                                 |         | 34                             |         | (201 | ) |
| Accounts payable                                                             |         | (6,430                         | )            | 853 |   |
| Accrued payroll and benefits                                                 |         | (608                           | )            | (884 | ) |
| Compensation to law firms                                                    |         | (7,956                         | )            | (2,600 | ) |
| Accrued liabilities                                                          |         | (249                           | )            | 3,371 |   |
| Deferred revenue                                                             |         | 19                             |         | 2,053 |   |
| Other royalties payable                                                      |         | (45                            | )            | (214 | ) |
| Taxes payable                                                                |         | 8                              |         | 690 |   |
| Other long-term liabilities                                                  |         | (1                             | )            | 27 |   |
| Net cash used in operating activities                                        |         | (17,702                        | )            | (5,206 | ) |
|                                                                         |         |                           |         |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |         |                           |         |   |   |
| Purchase of property and equipment                                           |         | (145                           | )            | (186 | ) |
| Purchase of available-for-sale securities                                    |         | (8,200                         | )            | (41,234 | ) |
| Proceeds from available-for-sale securities                                  |         | 20,909                         |         | 5,025 |   |
| Purchase of minority interest in Japanese subsidiary                         |         | —                         |         | (209 | ) |
| Net cash provided by (used in) investing activities                          |         | 12,564                         |         | (36,604 | ) |
|                                                                         |         |                           |         |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |         |                           |         |   |   |
| Proceeds from sale of common stock through employee stock purchase  program  |         | 373                            |         | 370 |   |
| Proceeds from exercise of common stock options                               |         | 205                            |         | 559 |   |
| Offering costs incurred in connection with Series A-1 issuance               |         | —                         |         | (212 | ) |
| Purchase of common stock                                                     |         | —                         |         | (2,414 | ) |
| Net cash provided by financing activities                                    |         | 578                            |         | (1,697 | ) |
|                                                                         |         |                           |         |   |   |
| EFFECT OF FOREIGN EXCHANGE RATES ON CASH                                     |         | 12                             |         | 121 |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                    |         | (4,560                         | )            | (43,507 | ) |
| CASH AND CASH EQUIVALENTS, beginning of period                               |         | 12,693                         |         | 64,428 |   |
| CASH AND CASH EQUIVALENTS, end of period                                     |         | $                              | 8,145        |   | $ | 21,042 |   |
|                                                                         |         |                           |         |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                            |         |                           |         |   |   |
|                                                                         |         |                           |         |   |   |
| Cash paid for taxes                                                          |         | $                              | 248          |   | $ | 274 |   |
|                                                                         |         |                           |         |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:         |         |                           |         |   |   |
|                                                                         |         |                           |         |   |   |
| Dividend in connection with exchange of Series A-1 for Series A  shares      |         | $                              | —       |   | $ | 6,305 |   |
|                                                                         |         |                           |         |   |   |
| Accretion of dividends                                                       |         | $                              | —       |   | $ | 1,496 |   |
|                                                                         |         |                           |         |   |   |
| Common stock subject to rescission                                           |         | $                              | 323          |   | $ | 188 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

5

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

 

## **(1) ORGANIZATION AND DESCRIPTION OF BUSINESS**

Thebusiness of The SCO Group, Inc. (the “Company”) focuses on marketing reliable,cost-effective UNIX software products and related services for thesmall-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 SystemV source code from The Santa Cruz Operation (now Tarantella, Inc.) in May 2001.

During the six monthsended April 30, 2005, the Company used cash of $17,702,000 in itsoperations.  The majority of this cashwas used to pay accounts payable, accrued liabilities and ongoing expensesrelated to the Company’s intellectual property litigation.  As of April 30, 2005, the Company had a totalof $14,192,000 in cash and cash equivalents and available-for-sale securitiesand an additional $7,974,000 in restricted cash, of which $3,967,000 isdesignated to be used as payments for experts, consultants and other expensesin the SCO Litigation.  As a result ofthe Engagement Agreement between the Company and the law firms representing itin its intellectual property litigation, the Company anticipates using cash ofapproximately $7,000,000 in the defense of its intellectual property litigationduring the remainder of the year ending October 31, 2005, which would leave theCompany approximately $11,159,000 in cash for its business operations as ofOctober 31, 2005.  The Company expectsthat its UNIX business will generate sufficient cash in the year ending October31, 2005 to cover its internal costs related to its SCOsource initiatives andintellectual property litigation, and believes that it will have sufficientcash resources to fund its operations through October 31, 2005.

In the event that cashrequired to fund operations and strategic initiatives exceeds the Company’scurrent cash resources and cash generated from operations, the Company will berequired to reduce costs and perhaps raise additional capital.  The Company may not be able to reduce costsin a manner that does not impair its ability to maintain its UNIX business andpursue its SCOsource initiatives.  TheCompany may also have difficulty raising capital.  If additional equity financing is available,it may not be available to the Company on attractive terms and may be dilutiveto the Company’s existing stockholders. In addition, if the Company’s stock price declines, it may not be ableto access the public equity markets on acceptable terms, if at all.  The Company’s ability to effect acquisitionsfor stock would also be impaired.

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

### **Basis of Presentation**

Theaccompanying unaudited condensed consolidated financial statements of theCompany have been prepared by the Company pursuant to the rules and regulationsof the Securities and Exchange Commission (“SEC”) on a basis consistent withthe Company’s audited annual financial statements, and, in the opinion ofmanagement, reflect all adjustments, consisting of normal recurringadjustments, necessary to present fairly the financial information set forththerein.  Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to SEC rules andregulations, although the 

 

6

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Company believes that the following disclosures,when read in conjunction with the audited annual financial statements and thenotes thereto included in the Company’s most recent annual report on Form 10-K,are adequate to make the information presented not misleading.  Operating results for the three and sixmonths ended April 30, 2005 are not necessarily indicative of the results thatmay be expected for the year ending October 31, 2005.

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

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during thereporting period.  Actual results coulddiffer from these estimates.  The Company’scritical accounting policies and estimates include, among others, revenuerecognition, allowances for doubtful accounts receivable, severance and exitcosts, impairment of long-lived assets, and valuation allowances againstdeferred income tax assets.

### **Revenue Recognition**

The Company recognizesrevenue in accordance with Statement of Position (“SOP”) 97-2, as modified bySOP 98-9.  The Company’s revenue isprimarily from three sources: (i) product license revenue, primarily fromproduct sales to resellers, end users and original equipment manufacturers (“OEMs”);(ii) technical support service revenue, primarily from providing technicalsupport and consulting services to end users; and (iii) licensing revenue fromits SCOsource intellectual property initiative.

The Company recognizesproduct revenue upon shipment if a signed contract exists, the fee is fixed ordeterminable, collection of the resulting receivable is probable and productreturns are reasonably estimable.

The majority of theCompany’s revenue transactions relate to product-only sales.  On occasion, the Company has revenuetransactions that have multiple elements (such as software products,maintenance, technical support services, 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 when the criteria for product revenuerecognition set forth above have been met. If VSOE of all undelivered elements exists, but VSOE does not exist forone or more delivered elements, then revenue is recognized using the residualmethod.  Under the residual method, thefair value of the undelivered elements is deferred and the remaining portion ofthe license fee is recognized as revenue in the period when persuasive evidenceof an arrangement is obtained assuming all other revenue recognition criteriaare met.

The Company recognizesproduct revenue from OEMs when the software is sold by the OEM to an end-usercustomer.  Revenue from technical supportservices and consulting services is recognized as the related services areperformed.  Revenue for maintenance isrecognized ratably over the maintenance period.

TheCompany considers an arrangement with payment terms longer than the Company’snormal business practice, which do not extend beyond 12 months, not to be fixedand determinable and revenue is recognized when the fee becomes due.  The Company typically provides stock rotationrights for sales made through its distribution channel and sales todistributors are recognized upon shipment by the distributor to end users.  For direct sales not through the Company’sdistribution channel, sales are typically non-refundable and non-

 

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cancelable. The Company estimates its product returns based on historical experienceand maintains an allowance for estimated returns, which is recorded as areduction to accounts receivable.

The Company’s SCOsourcelicensing revenue to date has been primarily generated from license agreementsto utilize the Company’s UNIX source code as well as from intellectual propertycompliance licenses.  The Companyrecognizes revenue from SCOsource licensing agreements when a signed contractexists, the fee is fixed and determinable, collection of the receivable isprobable and delivery has occurred.  Ifthe payment terms extend beyond the Company’s normal payment terms, revenue isrecognized as the payments become due.

**Pro Forma Fair Value ofStock-based Compensation**

The Company accounts forstock options issued to directors, officers and employees under AccountingPrinciples Board (“APB”) No. 25, “Accounting for Stock Issued to Employees, andRelated Interpretations.”  Under APB No.25, compensation expense is recognized if an option’s exercise price on themeasurement date is below the fair market value of the Company’s commonstock.  The Compensation expense, if any,is amortized to expense over the vesting period.

SFAS No. 148, “Accountingfor Stock-Based Compensation,” requires pro forma information regarding net income (loss) as if the Company hadaccounted for its stock options granted under the fair value method prescribedby SFAS No. 123, “Accounting for Stock-Based Compensation.”  The fair value for the Company’s stockoptions is estimated on the date of grant using the Black-Scholesoption-pricing model.

Withrespect to stock options and restricted stock awards granted and sharespurchased pursuant to the Company’s 2000 Employee Stock Purchase Plan (the “ESPP”)during the three and six months ended April 30, 2005 and 2004, the assumptionsused in the Black-Scholes option-pricing model are as follows:  
| ** **                        | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | *** *** |
|-----------------------------------|------------|----------------------------------|------------|--------------------------------|--------------|
| ** **                        | ** ** | **2005**                         | ** ** | **2004**                       | ** **   | **2005** | ** ** | **2004** | *** *** |
| Risk-free interest rate           |       | 3.7                              | %          | 2.9                            | %            | 3.6 | % | 2.6 | % |
| Expected dividend yield           |       | 0.0                              | %          | 0.0                            | %            | 0.0 | % | 0.0 | % |
| Volatility                        |       | 51.5                             | %          | 91.5                           | %            | 72.4 | % | 82.4 | % |
| Expected exercise life (in years) |       | 2.7                              |       | 3.0                            |         | 2.7 |   | 3.0 |   |

 

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Forpurposes of the pro forma disclosure, the estimated fair value of stockoptions, restricted stock awards and ESPP shares are amortized over the vestingperiod of the award.  The following isthe pro forma disclosure and the related impact on net loss to commonstockholders and the net loss to common stockholders per diluted common sharefor the three and six months ended April 30, 2005 and 2004 (in thousands,except per share amounts):

 
| ** **                                                                      | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss applicable to common stockholders:                                     |       |                             |       |                           |       |   |   |   |   |
| As reported                                                                     |       | $                                | (1,962     | )                              | $          | (14,726 | ) | $ | (4,923 | ) | $ | (17,212 | ) |
| Stock-based compensation included in reported net loss                          |       | 7                                |       | 163                            |       | 22 |   | 598 |   |
| Stock-based compensation under fair value method                                |       | (403                             | )          | (476                           | )          | (597 | ) | (1,283 | ) |
| Pro forma net loss applicable to common stockholders                            |       | $                                | (2,358     | )                              | $          | (15,039 | ) | $ | (5,498 | ) | $ | (17,897 | ) |
| Net loss applicable to common stockholders per basic and diluted  common share: |       |                             |       |                           |       |   |   |   |   |
| As reported                                                                     |       | $                                | (0.11      | )                              | $          | (1.04 | ) | $ | (0.28 | ) | $ | (1.23 | ) |
| Pro forma                                                                       |       | $                                | (0.13      | )                              | $          | (1.07 | ) | $ | (0.31 | ) | $ | (1.28 | ) |

 

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123R, “Share-Based Payment, an amendment ofFASB Statements Nos. 123 and 95,” which requires the measurement ofall employee share-based payments to employees, including grants of employeestock options, using a fair-value-based method and the recording of suchexpense in the Consolidated Statements of Operations and ComprehensiveLoss.  The accounting provisions ofSFAS No. 123R are effective for fiscal years beginning afterJune 15, 2005 and the Company will adopt SFAS No. 123R in thefirst quarter of fiscal year 2006.  Theabove disclosure for the three and six months ended April 30, 2005 and 2004shows the pro forma net loss and net loss per share as if the Company had useda fair-value-based method similar to the methods required under SFAS No. 123Rto measure compensation expense for employee stock incentive awards.  Although the Company has not yet determinedwhether the adoption of SFAS No. 123R will result in future amountsthat are similar to the current pro forma disclosure under SFAS No. 123,the Company is evaluating the requirements under SFAS No. 123R andexpects that the adoption could have a material impact on the Company’s resultsof operations.

**Cash and CashEquivalents**

The Company considersall investments purchased with original maturities of three or fewer months tobe cash equivalents.  Cash equivalentswere $5,298,000 and $2,633,000 as of April 30, 2005 and October 31, 2004,respectively.  Cash was $2,847,000 and$10,060,000 as of April 30, 2005 and October 31, 2004, respectively.

**Available-for-SaleSecurities**

Available-for-salesecurities are recorded at fair market value, based on quoted market prices,and unrealized gains and losses are recorded as a component of comprehensiveincome (loss).  Realized gains andlosses, which are calculated based on the specific-identification method, arerecorded in operations as incurred.

 

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Available-for-salesecurities totaled $6,047,000 as of April 30, 2005 and consisted of governmentagency securities and corporate notes. Any available-for-sale securities in an unrealized loss position as ofApril 30, 2005 were not impaired at acquisition and the decline in fair valueis primarily attributable to interest rate fluctuations.  A decline in the market value of anyavailable-for-sale security below cost that is deemed other than temporaryresults in a charge to earnings and establishes a new basis for the security.

**Earnings per Share**

Basic net income (loss)per common share (“Basic EPS”) is computed by dividing net income (loss) by theweighted average number of common shares outstanding.  Diluted net income (loss) per common share (“DilutedEPS”) is computed by dividing net income (loss) by the sum of the weightedaverage number of common shares outstanding and the dilutive potential commonshare equivalents then outstanding. Potential common share equivalents consist of the weighted average ofshares issuable upon the exercise of outstanding stock options, restrictedstock awards, warrants to acquire common stock and preferred stock convertibleinto common shares.  If dilutive, theCompany computes Diluted EPS using the treasury stock method.

The following table is areconciliation of the numerator and denominator of Basic EPS to the numerator anddenominator of Diluted EPS for the three and six months ended April 30, 2005and 2004 (in thousands, except per share amounts):
| *** ***                                       | *** *** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|----------------------------------------------------|--------------|----------------------------------|------------|--------------------------------|------------|
| *** ***                                       | *** *** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                               |         |                             |       |                           |       |   |   |   |   |
| Numerator:                                         |         |                             |       |                           |       |   |   |   |   |
| Net loss applicable to common stockholders         |         | $                                | (1,962     | )                              | $          | (14,726 | ) | $ | (4,923 | ) | $ | (17,212 | ) |
| Denominator:                                       |         |                             |       |                           |       |   |   |   |   |
| Weighted average common shares outstanding         |         | 17,913                           |       | 14,100                         |       | 17,831 |   | 13,960 |   |
| Stock options                                      |         | —                           |       | —                         |       | — |   | — |   |
| Restricted stock                                   |         | —                           |       | —                         |       | — |   | — |   |
| Warrants                                           |         | —                           |       | —                         |       | — |   | — |   |
| Weighted average diluted common shares outstanding |         | 17,913                           |       | 14,100                         |       | 17,831 |   | 13,960 |   |
| Basic and diluted EPS                              |         | $                                | (0.11      | )                              | $          | (1.04 | ) | $ | (0.28 | ) | $ | (1.23 | ) |
|                                               |         |                             |       |                           |       |   |   |   |   |
| Excluded anti-dilutive common share equivalents    |         | 3,696                            |       | 6,665                          |       | 3,696 |   | 6,665 |   |

 

The excludedanti-dilutive common share equivalents are not included in the computation ofDiluted EPS as their inclusion would be anti-dilutive to the loss per share.

**Income Taxes**

                In October 2004, the AmericanJobs Creation Act (the “AJCA”) was signed into law.  The AJCA includes a deduction of 85 percentof certain foreign earnings that are repatriated in the AJCA.  The Company may elect to apply this provisionto qualifying earnings repatriations in fiscal year 2005.  The Company does not believe that it will haveany foreign earnings repatriation under the AJCA during fiscal year 2005.

 

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**Reclassifications**

                Certainreclassifications have been made to the prior period amounts to conform to thecurrent period presentation.  Thereclassifications had no effect on net income for the prior periods.

**(3) INTANGIBLE ASSETS**

The following tableshows the activity related to amortized intangible assets for the six monthsended April 30, 2005 as well as the remaining unamortized balances as of April30, 2005 (in thousands):
| ** **                     | ** ** | **As of**

**October 31, 2004** | ** ** | **Six Months Ended**

**April 30, 2005** | ** ** | **As of**

**April 30, 2005** | ** ** |
|--------------------------------|------------|---------------------------------|------------|------------------------------------------|------------|-------------------------------|------------|
| ** **                     | ** ** | **Net Book Value**              | ** ** | **Amortization**

**Expense**            | ** ** | **Impairment**

**Loss**      | ** ** | **Net Book Value** | ** ** |
| Amortizable intangible assets: |       |                            |       |                                     |       |                          |       |   |   |
| Distribution/reseller channel  |       | $                               | 4,636      |                                     | $          | (1,160                        | )          | $ | — |   | $ | 3,476 |   |
| Acquired technology            |       | 673                             |       | (167                                     | )          | —                        |       | 506 |   |
| Trade name                     |       | 104                             |       | (26                                      | )          | —                        |       | 78 |   |
| Total intangible assets        |       | $                               | 5,413      |                                     | $          | (1,353                        | )          | $ | — |   | $ | 4,060 |   |

 

Of the $1,353,000 inamortization expense, $1,186,000 was classified as amortization of intangibleassets in operating expenses and the remaining $167,000 was classified as costof SCOsource licensing revenue.

**(4) INVESTMENTS**

**Sale of Troll Tech Shares**

In December 1999, the Company and The Canopy Group, Inc. (“Canopy”), aformer holder of the Company’s common stock, entered into an agreement withTroll Tech AS (“Troll Tech”) and its stockholders.  Pursuant to the agreement, the Companyacquired shares of Troll Tech in exchange for shares of the Company, and Canopyacquired shares of Troll Tech in exchange for $1,000,000.  The Company recorded its investment in TrollTech’s common stock at $400,000, based on the cash price per share paid byCanopy.  The Company determined that thecash price per share paid by Canopy was the most reliable evidence of the valueof Troll Tech’s common stock.  Duringfiscal year 2001, management determined that the carrying value of theinvestment in Troll Tech of $400,000 would most likely not be recoverable, andthe investment was written down to $0.

During the second quarter of fiscal year 2005, theCompany received notice from Troll Tech that a third-party investor wasinterested in acquiring the Company’s shares of Troll Tech.  On March 14, 2005, the Company receivedproceeds of $779,100 for the Troll Tech shares. The Company accounted for the sale and proceeds of the Troll Tech sharesin the second quarter of fiscal year 2005 when it received the proceeds fromthe shares.  All amounts related to thebook value of the shares had been written off during fiscal year 2001, and theCompany recorded the proceeds received as a component of other income in itsstatements of operations for the three and six months ended April 30, 2005.

 

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**(5) COMMITMENTS AND CONTINGENCIES**

**Litigation**

The following includes updated information relating to certain of theCompany’s material legal proceedings as previously reported in the Company’sannual report on Form 10-K for fiscal year 2004, and previously updated in theCompany’s quarterly report on Form 10-Q for the fiscal quarter ended January31, 2005.

*IBM Corporation*

On or about March 6, 2003,the Company filed a complaint against IBM Corporation (“IBM”).  This action is pending in the United StatesDistrict Court for the District of Utah, under the title The SCO Group, Inc. v.International Business Machines Corporation, Civil No. 2:03CV0294.  This action includes, among other things,Company claims against IBM for breach of contract, copyright infringement,tortious interference, and unfair competition relating to IBM’s alleged use anddistribution of information concerning the UNIX source code and derivativeworks in connection with its efforts to promote the Linux operatingsystem.  IBM has responded to the Company’sclaims and made counterclaims against the Company.

Following ahearing on October 19, 2004, on January 19, 2005, the United States MagistrateJudge overseeing the case issued an order granting in part and denying in partdiscovery applications that the Company had made.  The Court ordered IBM to produce much of theinformation, including source code, revision information, and programmercontribution information, that the Company had previously requested.  The court also struck the Amended SchedulingOrder and directed the parties to submit a proposed amended scheduling order tothe court, which both parties have done. The District Court heard argument on the proposed schedules on April 21,2005 and took the matter under advisement. It is anticipated that the Court will issue a new scheduling order inthe near future.

In response tothe Magistrate Court’s Order, IBM filed, on February 11, 2005, a Motion forReconsideration of the portion of the Order that required IBM to produceprogrammer-contribution information for 3,000 people.  IBM also filed, on March 9, 2005,  a Motion for a 45-day Extension of Time toComply with the Court’s January 18 Order as it applies to materials that arenot the subject of IBM’s above-referenced Motion for Reconsideration.  On March 16, 2005, the Court granted theextension and entered an order requiring IBM to produce those materials by May3, 2005.  With respect to the materialscovered by IBM’s Motion for Reconsideration, the Court granted IBM’s request tostay its discovery obligations pending the Court’s resolution of its motion.

On April 19, 2005,the Magistrate Court ruled on IBM’s reconsideration motion.  The Court declined to strike its priorrequirement that IBM produce documents from the files of the 3,000 individualswho made the most contributions and changes to the development of AIX andDynix.  The Court reiterated itsrequirement that IBM produce programmer’s notes, design documents, whitepapers, comments and notes, contact information, specific changes made to code,and all relevant non-privileged documents from the files of the 100 individualswho made the most contributions and changes to the development of AIX andDynix; ordered IBM to provide a privilege log for any documents withheld fromthe files of those 100 individuals; and required IBM to comply within 90days.  The Court deferred the remainderof IBM’s required production pending the Company’s review of theabove-described discovery.  The Courtalso reiterated that IBM is required to produce all non-public Linuxcontribution information and directed IBM to produce all such informationwithin 75 days.

 

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                On February 9, 2005, the UnitedStates District Judge ruled on several pending dispositive motions.  The Court denied the three motions forpartial summary judgment that IBM had filed on the Company’s contract claims,on IBM’s eighth counterclaim for copyright infringement, and on IBM’s tenth counterclaimfor a declaration of non-infringement of the Company’s copyrights.  The Court denied each of those motionswithout prejudice to IBM’s renewing or refiling the motions after discovery iscomplete.  The Court also denied theCompany’s motion to stay or dismiss IBM’s tenth counterclaim.  The Court ordered that no further dispositivemotions could be filed until the close of discovery, except by stipulation ofthe parties, and vacated its prior order, dated September 30, 2004, to theextent that order had granted permission to file dispositive motions before theclose of discovery.

Additionaldiscovery motions that the Company has filed are also pending before theCourt.  On January 12, 2005, the Companyfiled its Motion to Compel IBM to produce IBM CEO Samuel J. Palmisano forDeposition.  The parties have fullybriefed this motion, and the Court heard argument on that motion on April 21,2005.  The Court took the matter underadvisement.  The parties have also nowfully briefed the Company’s December 23, 2004 Renewed Motion to CompelDiscovery, which seeks to compel IBM’s compliance with prior Court ordersrelating to IBM’s obligation to produce (1) all documents pertaining to Linuxfrom the files of high-level IBM executives and board members; and (2) tocompel IBM to produce witnesses to testify on several topics in two depositionnotices that SCO has served on IBM.  TheCourt has not set a hearing date for this motion.

In addition tothe materials that have been publicly filed with the Court, certain informationhas been filed under seal in accordance with the protective order entered inthe case.  On November 30, 2004, a thirdparty moved to intervene in the case for the purpose of challenging the sealingof certain documents filed with the Court, and additional groups subsequentlyjoined in that motion.  Followingargument on April 26, 2005, by Order dated April 28, 2005, the Court denied theintervention motion.  In its Order, theCourt set forth various procedures to minimize the risk that documents would beimproperly filed under seal.

The Companyhas also filed a motion for leave to file a third amended complaint in order toassert an additional copyright claim against IBM in the case.  The Court heard argument on that fullybriefed motion on April 21, 2005 and took the matter under advisement.

In support ofits pending motion to amend, the Company argued that IBM would not beprejudiced by the proposed amendment because, among other things, the Company’snew claim pertained to issues already covered by IBM’s own Ninth Counterclaim,which seeks a broad declaratory judgment of non-infringement relating toAIX.  On February 18, 2005, IBM filed aMotion for Entry of Order Limiting the Scope of Its Ninth Counterclaim.  That motion has also been briefed, but noargument date has been set.

Discovery iscontinuing in the case.  The Company isreviewing that discovery and currently anticipates that it will seek to amendits complaint in the near future in order to assert additional claims againstIBM.

*Red Hat, Inc.*

OnAugust 4, 2003, Red Hat, Inc. (“Red Hat”) filed a complaint against theCompany.  The action is pending in theUnited States District Court for the District of Delaware under the casecaption Red Hat, Inc. v. The SCO Group, Inc., Civil No. 03-772.  Red Hat asserts that the Linux operatingsystem does not infringe on the Company’s UNIX intellectual property rights andseeks a declaratory judgment for non-infringement of copyrights and nomisappropriation of trade secrets.  Inaddition, Red Hat claims the Company has engaged in false advertising inviolation of the Lanham Act, deceptive trade practices, unfair competition,tortious interference 

 

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with prospective business opportunities, tradelibel and disparagement.  On April 6,2004, the court denied the Company’s motion to dismiss this case; however, thecourt stayed the case and requested status reports every 90 days regarding thecase against IBM.  Red Hat filed a motionfor reconsideration, which the Court denied on March 31, 2005.  The Company intends to vigorously defend thisaction.  In the event the stay is liftedand Red Hat is allowed to pursue its claims, we will likely assertcounterclaims against Red Hat.

*Novell, Inc.*

OnJanuary 20, 2004, the Company filed suit in Utah state court againstNovell, Inc. (“Novell”) for slander of title seeking relief for itsalleged bad faith effort to interfere with the Company’s ownership ofcopyrights related to its UNIX source code and derivative works and itsUnixWare product.  The case, afterremoval to federal court, is pending in the United States District Court forthe District of Utah under the caption The SCO Group, Inc. v. Novell, Inc.,Civil No. 2:04CV00139.  In the lawsuit,the Company requested preliminary and permanent injunctive relief as well asdamages.  Through these claims, theCompany seeks to require Novell to assign to the Company all copyrights that itbelieves Novell has wrongfully registered, prevent Novell from representing anyownership interest in those copyrights and require Novell to retract orwithdraw all representations it has made regarding its purported ownership ofthose copyrights.

Novellhas filed a motion to dismiss claiming, among other things, that Novell’s falsestatements were not uttered with malice and are privileged under the law.  That motion has been briefed by the partiesand the Court heard the argument on the motion on May 25, 2005.  The Court took the matter underadvisement.  The Company intends to continueto vigorously pursue its claims against Novell.

*DaimlerChrysler Corporation*

Onor about March 3, 2004, the Company brought suit against DaimlerChryslerCorporation (“DaimlerChrysler”) for its alleged violations of its UNIX licenseagreement with the Company.  The lawsuitalleges that DaimlerChrysler breached its UNIX software agreement by failing toprovide an adequate or timely certification of its compliance with thatagreement as the Company requested.  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 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.

Inresponse to DaimlerChrysler’s motion to dismiss, the court grantedDaimlerChrysler’s motion as to the substance of DaimlerChrysler’scertification, but denied the motion as to whether the certification wastimely.  Based on this ruling, theCompany filed a motion to stay the case pending the clarification of certainissues in the IBM litigation.  The courtdenied the motion to stay.  Based on astipulation of the parties, however, the court signed an order of dismissalwithout prejudice.  The appellate courthas dismissed the Company’s appeal of the July 21, 2004 ruling finding that theorder was not a final, appealable order; the Company is evaluating its optionsregarding the appellate court’s ruling.

*AutoZone, Inc.*

                Onor about March 2, 2004, the Company brought suit against AutoZone, Inc. (“AutoZone”)for its alleged violations of the Company’s UNIX copyrights through its use ofLinux.  The lawsuit alleges copyrightinfringement by AutoZone by, among other things, running versions of the Linux 

 

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operating system thatcontain proprietary material from UNIX System V.  The lawsuit, filed in United States DistrictCourt in Nevada, requests injunctive relief against AutoZone’s further use orcopying of any part of the Company’s copyrighted materials and also requestsdamages as a result of AutoZone’s infringement in an amount to be proven attrial.  In response to AutoZone’s motionto transfer the case to Tennessee or stay the case, the federal court in Nevadagranted AutoZone’s motion to stay the case, with 90-day status reports to thecourt, and denied without prejudice AutoZone’s motion to transfer the case toTennessee.  The federal court allowed theparties to take limited expedited discovery relating to the issue ofpreliminary injunctive relief which discovery was concluded in May 2005.

TheCompany has concluded the initial discovery allowed by the court and filed itsreport with the court on May 27, 2005. Contrary to AutoZone’s own statements to the court, the Company foundthrough discovery, including depositions and other admissions of AutoZone, manyinstances of copying of programs containing SCO OpenServer code.  AutoZone has represented that it has nowremoved all of the SCO code and proprietary information it copied or used inits migration to Red Hat Linux.  BecauseAutoZone represents it has removed or otherwise is not using SCO code andproprietary information, the Company currently does not intend to move for apreliminary injunction.  AutoZone doesnot admit that it violated the Company’s rights or caused the Company damage inthat migration process, which are still points of dispute between theparties.  Given the stay issued by theCourt in the case, the Company reserves the right to pursue infringement anddamages in the future based on these issues and other issues stayed by theCourt.

*IPO Class Action Matter*

The Company is an issuerdefendant in a series of class action lawsuits involving over 300 issuers thathave been consolidated under In re Initial Public Offering SecuritiesLitigation, 21 MC 92 (SAS).  Theconsolidated complaint alleges, among other things, certain improprietiesregarding the underwriters’ conduct during the Company’s initial publicoffering and the failure to disclose such conduct in the registration statementin violation of the Securities Act of 1933, as amended.

The plaintiffs, the issuersand the insurance companies have negotiated an agreement to settle the disputebetween the plaintiffs and the issuers. All parties, including the plaintiffs, issuers and insurance companies,have executed this settlement agreement and the settlement agreement has beensubmitted to the court for approval.  Ifthe settlement agreement is approved by the court, and if no cross-claims,counterclaims or third-party claims are later asserted, this action will bedismissed with respect to the Company and its directors.

The Company has notified itsunderwriters and insurance 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 and will not exceed the $200,000 self-insured retention already paidor accrued by the Company.

*Other Matters*

In April 2003, a formerIndian distributor of the Company filed a claim in India, requesting summaryjudgment for payment of $1,428,000, and an order that the Company trade inIndia only through the distributor and/or give a security deposit until theclaim is paid.  The distributor claimsthat the Company is responsible to repurchase certain software products and toreimburse the distributor for certain other operating costs.  The distributor additionally requested thatthe Indian courts grant interim relief in the form of attachment of localassets.  Management does not believe thatthe Company is responsible to reimburse the distributor for any operating 

 

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costs and also believes thatthe return rights related to any remaining inventory have lapsed.  Discovery has commenced and hearings on therequests for interim relief have been held and are ongoing.  The Company intends to vigorously defend thisaction.

Pursuit and defense of theabove-mentioned matters will be costly, and management expects the costs forlegal fees and related expenses will be substantial.  The ultimate outcome or potential effect onthe Company’s results of operations or financial position of theabove-mentioned matters is not currently known or determinable.

**               **The Company isa party to certain other legal proceedings arising in the ordinary course ofbusiness.  Management believes, after consultationwith legal counsel, that the ultimate outcome of such legal proceedings willnot have a material adverse effect on the Company’s results of operations orfinancial position.

**Grants of Unregistered StockOptions; Potential Interest and Penalties Related to Rescission Rights**

                TheCompany believes certain shares and options granted under its 1998 Stock OptionPlan, 1999 Omnibus Stock Option Plan, the ESPP, 2002 Omnibus Stock IncentivePlan, and 2004 Omnibus Stock Incentive Plan (collectively, the “EquityCompensation 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 Equity Compensation Plans or recover damages if they no longer ownthe shares or hold unexercised options, subject to applicable statutes oflimitations.  Additionally, regulatoryauthorities may require the Company to pay fines or impose othersanctions.  Although the Companycontinues to evaluate the possible actions it may take, the Company may make arescission offer to certain plan participants entitled to rescission rightssubject to obtaining required regulatory approvals.

                TheCompany believes certain of its stock option grants made since February 2003may have also violated applicable securities laws in California, Georgia andpossibly other states 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.

                TheCompany believes that it is reasonably possible that some option holders mayaccept a rescission offer, but the Company is unable to estimate the number ofparticipants who might accept a rescission offer and the amount of potentialdamages that it would be required to pay under a rescission offer.  Since any loss is considered reasonablypossible but not estimable, the Company has not recorded a liability for thiscontingency.

                The Company may also be requiredto pay interest and penalties up to statutory limits in connection with planparticipants making rescission claims or in connection with any rescissionoffer.  The Company believes that it isreasonably possible that it may be required to pay interest and penalties, butit is not able to estimate an amount.

 

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

As described in Note 5,certain participants in the Equity Compensation Plans have a right to rescindtheir purchases of shares under the Plans or recover damages if they no longerown the shares or hold unexercised options, subject to applicable statutes oflimitations.

Accounting SeriesRelease (“ASR”) No. 268 and Emerging Issues Task Force (“EITF”) Topic D-98require that stock subject to rescission or redemption requirements outside thecontrol of the Company to be classified outside of permanent equity.  Theexercise of the rescission right is at the holders’ discretion, but exercise ofthat right may depend in part on the fair value of the Company’s common stock,which is outside of the Company’s and the holders’ control.  Consequently, common stock subject torescission is classified as temporary equity. If the Company’s possible rescission offer is made and accepted by planparticipants holding shares acquired under the Equity Compensation Plans orotherwise entitled to recover damages from the Company in respect of suchshares they have sold, or such plan participants otherwise make rescissionclaims against the Company, the Company could be required to make aggregatepayments to these plan participants of up to $851,000 in the aggregate,excluding interest and other possible fees, based upon shares outstanding underthe Equity Compensation Plans as of April 30, 2005.

In the event the Companycompletes a rescission offer or plan participants otherwise exercise rescissionrights, any amounts the Company may pay to plan participants, excludinginterest and other possible charges, will be deducted from common stock subjectto rescission, and, in the event a plan participant declines a rescission offeror otherwise is determined to no longer have a rescission right, any remainingamounts recorded to common stock subject to rescission will be recorded aspermanent equity.

**(7) STOCKHOLDERS’ EQUITY**

**Stock Options**

During the three and sixmonths ended April 30, 2005, the Company granted options to purchase 0 and631,000 shares of common stock with an average exercise price of $4.71,respectively, per share.  None of thesestock options were granted with an exercise price below the quoted market priceon the date of grant.  During the threeand six months ended April 30, 2005, options to purchase approximately 7,000and 142,000 shares of common stock were exercised with an average exerciseprice of $0.95 and $1.47, respectively, per share.  As of April 30, 2005, there wereapproximately 3,437,000 stock options outstanding with a weighted averageexercise price of $4.32 per share.

**Change in Control Agreements**

OnDecember 10, 2004, the Company entered into Change in Control Agreements withthe following executive officers:  DarlC. McBride; Bert B. Young; Christopher Sontag; Jeff F. Hunsaker; and Ryan E.Tibbitts (each, an “Officer”).  Eachagreement is effective as of December 10, 2004.

Pursuantto the terms of each Agreement, the Officer agrees that he or she will notvoluntarily leave the employ of the Company in the event any individual,corporation, partnership, company or other entity takes certain steps to effecta Change in Control (as defined in the Agreement) of the Company, until theattempt to effect a Change in Control has terminated, or until a Change inControl occurs.

Ifthe Officer is still employed by the Company when a Change in Control occurs,any stock, stock option or restricted stock granted to the Officer by theCompany that would have 

 

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becomevested upon continued employment by the Officer shall immediately vest in fulland become exercisable notwithstanding any provision to the contrary of suchgrant and shall remain exercisable until it expires or terminates in accordancewith its terms.  Each Officer shall besolely responsible for any taxes that arise or become due pursuant to theacceleration of vesting that occurs pursuant to the Agreement.

Theadoption of the Change in Control Agreements allows for accelerated vesting onall outstanding shares of common stock and represents a modification to theunderlying stock option award.  Inaccordance with Financial Accounting Standards Board (“FASB”) InterpretationNo. 44 “Accounting for Certain Transactions Involving Stock Compensation,” theCompany has calculated the total intrinsic value of the awards of $2,012,000which represents the value of the awards that were subject to theacceleration.  During the three and sixmonths ended April 30, 2005, this amount had not been recorded in the condensedconsolidated financial statements as an event to trigger the acceleration wasnot considered probable.

**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 theCompany’s shares in the open market or through private transactions and toprevent an acquirer from gaining control of the Company without offering a fairprice to all of the Company’s stockholders.

                Underthe terms of the Rights Plan, Series A Junior Participating Preferred Stockpurchase rights were distributed as a dividend at the rate of one right foreach share of common stock of the Company held by stockholders of record as ofthe close of business on August 30, 2004, and will be distributed to holders ofsubsequently issued shares of common stock. The Rights Plan would be triggered if a person or group acquiredbeneficial ownership of 15 percent or more of the Company’s common stock otherthan pursuant to a board-approved tender or exchange offer or commences, orpublicly announces an intention to commence, a tender or exchange offer uponconsummation of which such person or group would beneficially own 15 percent ormore of the Company’s common stock.  Thevalue of the purchase rights is immaterial as of April 30, 2005.

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

 

Effective March 11, 2005, The CanopyGroup (“Canopy”) transferred all of its shares of the Company’s common stock toRalph J. Yarro III, the Chairman of the Company’s Board of Directors.

**(8)CONCENTRATION OF RISK**

As of April 30, 2005 and October 31,2004, the Company had no customers who made up more than 10 percent of theending accounts receivable balance.

Duringthe three and six months ended April 30, 2005 and 2004, no single customeraccounted for more than 10 percent of total revenue.

 

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**(9) RELATED PARTY TRANSACTIONS**

As of October 31, 2004,Canopy owned approximately 31 percent of the Company’s issued and outstandingcommon stock.  As described in Note 7, onMarch 11, 2005, Canopy transferred all of its shares of common stock to RalphJ. Yarro III.

On April 30, 2003, theCompany and Center 7, Inc. (“C7”) entered into a Marketing and DistributionMaster Agreement (the “Marketing Agreement”) and an Assignment Agreement.  On October 2, 2003, C7 assigned theAssignment Agreement to Vintela, Inc. (“Vintela”) and Vintela and the Companyentered into a new marketing agreement (the “Vintela Agreement”).  Both C7 and Vintela are majority owned byCanopy.  Under the Vintela Agreement, theCompany was appointed as a worldwide distributor for Vintela products toco-brand, market and distribute these products.

Under the AssignmentAgreement, the Company assigned the copyright applications, patents andcontracts related to Volution Manager, Volution Authentication, Volution Onlineand Volution Manager Update Service (collectively, the “Assigned Software”).  As consideration for this assignment, C7issued, and Vintela assumed, a $500,000 non-recourse promissory note payable tothe Company, secured by the Assigned Software. This note was originally due on April 30, 2005 with interest payable ata rate of one percent above the prime rate as reported in the Wall StreetJournal.

In late November 2004,the Company entered into discussions with Vintela with respect to thecancellation of the Marketing Agreement and repayment of the Note.  It was later determined and decided onceVintela had received funding from an outside third party, the Company agreedwith Vintela to forego any interest charges on the promissory note in returnfor an immediate payment of the $500,000. On December 9, 2004, the Company received the $500,000 payment fromVintela and forgave the outstanding interest charges associated with thepromissory note.

At the time thepromissory note was executed, the Company had no recorded basis in the AssignedSoftware.  Because the transfer of theAssigned Software was to a related party in exchange for a promissory note andthere was substantial doubt concerning the ability of C7 to repay the debt asthey were not profitable and being funded by Canopy, no gain was recognized bythe Company until payment was received on December 9, 2004.  The Company recorded the $500,000 received asa component of other income in its statement of operations for the six monthsended April 30, 2005.

**(10) SEGMENT INFORMATION**

The Company’s resourcesare allocated and operating results managed to the operating income (loss)level for each of the Company’s segments: UNIX and SCOsource.  Both segments are based on the Company’s UNIXintellectual property.  The UNIX businesssells and distributes UNIX products and services through an extensivedistribution channel and to corporate end-users and the SCOsource businessenforces and protects the Company’s UNIX intellectual property.

Duringfiscal year 2004, in an effort to maximize the assets and resources of the UNIXand SCOsource business segments and to best represent management’s view ofbusiness operations, the Company directed resources and reviewed financialinformation for its UNIX and SCOsource segments.

 

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Segment disclosures forthe Company are as follows for the three and six months ended April 30, 2005(in thousands):

| ** **                    | ** ** | **Three Months Ended April 30, 2005** | ** ** |
|-------------------------------|------------|---------------------------------------|------------|
| ** **                    | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **UNIX**                              | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                          |       |                                  |       |   |   |   |   |
| Revenue                       |       | $                                     | 9,228      |   | $ | 30 |   | $ | 9,258 |   |
| Cost of revenue               |       | 1,309                                 |       | 2,889 |   | 4,198 |   |
| Gross margin (deficit)        |       | 7,919                                 |       | (2,859 | ) | 5,060 |   |
| Sales and marketing           |       | 2,956                                 |       | 7 |   | 2,963 |   |
| Research and development      |       | 2,027                                 |       | 90 |   | 2,117 |   |
| General and administrative    |       | 1,866                                 |       | 170 |   | 2,036 |   |
| Other                         |       | 600                                   |       | — |   | 600 |   |
| Total operating expenses      |       | 7,449                                 |       | 267 |   | 7,716 |   |
| Income (loss) from operations |       | $                                     | 470        |   | $ | (3,126 | ) | $ | (2,656 | ) |

 

 

| *** ***               | *** *** | **Three  Months Ended April 30, 2004** | *** *** |
|----------------------------|--------------|----------------------------------------|--------------|
| ** **                 | ** **   | ** **                             | ** **   | ** ** | ** ** | ** ** | ** ** |
| *** ***               | *** *** | **UNIX**                               | ** **   | **SCOsource** | ** ** | **Total** | *** *** |
|                       |         |                                   |         |   |   |   |   |
| Revenue                    |         | $                                      | 10,126       |   | $ | 11 |   | $ | 10,137 |   |
| Cost of revenue            |         | 1,891                                  |         | 4,567 |   | 6,458 |   |
| Gross margin (deficit)     |         | 8,235                                  |         | (4,556 | ) | 3,679 |   |
| Sales and marketing        |         | 4,117                                  |         | 581 |   | 4,698 |   |
| Research and development   |         | 2,797                                  |         | 71 |   | 2,868 |   |
| General and administrative |         | 1,710                                  |         | — |   | 1,710 |   |
| Other                      |         | 3,577                                  |         | — |   | 3,577 |   |
| Total operating expenses   |         | 12,201                                 |         | 652 |   | 12,853 |   |
| Loss from operations       |         | $                                      | (3,966       | ) | $ | (5,208 | ) | $ | (9,174 | ) |

 

 

| ** **                    | ** ** | **Six  Months Ended April 30, 2005** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|
| ** **                    | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **UNIX**                             | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                          |       |                                 |       |   |   |   |   |
| Revenue                       |       | $                                    | 18,023     |   | $ | 100 |   | $ | 18,123 |   |
| Cost of revenue               |       | 2,702                                |       | 6,382 |   | 9,084 |   |
| Gross margin (deficit)        |       | 15,321                               |       | (6,282 | ) | 9,039 |   |
| Sales and marketing           |       | 5,746                                |       | 154 |   | 5,900 |   |
| Research and development      |       | 3,995                                |       | 202 |   | 4,197 |   |
| General and administrative    |       | 3,538                                |       | 261 |   | 3,799 |   |
| Other                         |       | 1,208                                |       | — |   | 1,208 |   |
| Total operating expenses      |       | 14,487                               |       | 617 |   | 15,104 |   |
| Income (loss) from operations |       | $                                    | 834        |   | $ | (6,899 | ) | $ | (6,065 | ) |

 

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| * *                   | * * | **Six  Months Ended April 30, 2004** | ** ** |
|----------------------------|----------|--------------------------------------|------------|
| * *                   | * * | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| * *                   | * * | **UNIX**                             | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                       |     |                                 |       |   |   |   |   |
| Revenue                    |     | $                                    | 21,498     |   | $ | 31 |   | $ | 21,529 |   |
| Cost of revenue            |     | 4,018                                |       | 8,090 |   | 12,108 |   |
| Gross margin (deficit)     |     | 17,480                               |       | (8,059 | ) | 9,421 |   |
| Sales and marketing        |     | 9,128                                |       | 591 |   | 9,719 |   |
| Research and development   |     | 5,477                                |       | 98 |   | 5,575 |   |
| General and administrative |     | 3,882                                |       | 22 |   | 3,904 |   |
| Other                      |     | 4,799                                |       | — |   | 4,799 |   |
| Total operating expenses   |     | 23,286                               |       | 711 |   | 23,997 |   |
| Loss from operations       |     | $                                    | (5,806     | ) | $ | (8,770 | ) | $ | (14,576 | ) |

 

Intangible assets, whichconsist of the Company’s reseller channel, trade name and technology, have beenassigned to the Company’s UNIX and SCOsource segments and consist of thefollowing as of April 30, 2005 and October 31, 2004 (in thousands): 

| *** ***                           | *** *** | **April 30,**

**2005** | ** ** | **October 31,**

**2004** | *** *** |
|----------------------------------------|--------------|-------------------------|------------|---------------------------|--------------|
| Intangible assets:                     |         |                    |       |                      |         |
| UNIX (reseller channel and trade name) |         | $                       | 3,554      |                      | $            | 4,740 |   |
| SCOsource (UNIX technology)            |         | 506                     |       | 673                       |         |
| Total intangible assets and goodwill   |         | $                       | 4,060      |                      | $            | 5,413 |   |

 

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** **

**ITEM 2.   ****                                           ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

*This Management’s Discussion andAnalysis of Financial Condition and Results of Operations and other parts ofthis quarterly report on Form 10-Q contain forward-looking statements thatinvolve risks and uncertainties. Forward-looking statements can also be identified by words such as “intends,”“anticipates,” “expects,” “believes,” “plans,” “predicts,” and similarterms.  Forward-looking statements arenot guarantees of future performance and our actual results may differsignificantly from the results discussed in the forward-lookingstatements.  Factors that might causesuch differences include, but are not limited to, those set forth below under “Forward-LookingStatements” and “Risk Factors” and elsewhere in this Form 10-Q.  The following discussion should be read inconjunction with our consolidated financial statements and notes theretoincluded in this Form 10-Q and our annual report on Form 10-K for the yearended October 31, 2004 filed with the Securities and Exchange Commission,including the audited financial statements and management’s discussion andanalysis contained therein.  Allinformation presented herein is based on the three and six months ended April30, 2005.  We assume no obligation torevise or update any forward-looking statements for any reason, except asrequired by law.*

**Overview**

*Historical Background. *Weoriginally incorporated as Caldera Systems, Inc., a Utah corporation (“CalderaSystems”), and reincorporated as a Delaware corporation on March 6, 2000.  In March 2000, we completed an initial publicoffering of our common stock.  On May 7, 2001, we formed a new holdingcompany in Delaware under the name of Caldera International, Inc. to acquiresubstantially all of the assets and operations of the server and professionalservices groups of The Santa Cruz Operation (now Tarantella, Inc.).  In connection with this acquisition, CalderaSystems became a wholly-owned subsidiary of Caldera International, Inc.  Formerholders of shares and options to purchase shares of Caldera Systems received anequal number of shares and options to purchase shares in Caldera International, Inc.  OnMay 16, 2003, our stockholders approved our corporate name change to The SCOGroup, Inc.  As used herein, “we,” “us”and “the Company” refer to The SCO Group, Inc.

*Recent Developments.*** **Asdescribed elsewhere in this Form 10-Q, we issued shares andgranted options under our 1998 Stock Option Plan, our 1999 Omnibus StockIncentive Plan, the 2000 Employee Stock Purchase Plan (the “ESPP”), our 2002Omnibus Stock Incentive Plan, and our 2004 Omnibus Stock Incentive Plan(collectively, the “EquityCompensation Plans”) 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 Equity Compensation Plans or recover damages if they no longer ownthe shares or hold unexercised options, subject to applicable statutes oflimitations.  Although we are evaluatingthe possible actions we may take in response to these securities law complianceissues, we may make a rescission offer to certain plan participants entitled torescission rights subject to obtaining required regulatory approvals.  If our potential rescission offer is made andaccepted by all plan participants holding certain ESPP shares and all sharesacquired from the exercise of stock options, or such participants otherwisemake rescission claims against us, we could be required to make aggregatepayments to these plan participants of up to $851,000.  This amount is based on shares issuedpursuant to the ESPP and shares issued upon the exercise of stock options thathave been retained by plan participants as of April 30, 2005 and excludesinterest and other charges we may be required to pay since any loss isconsidered reasonably possible but not estimable.  We may face additional rescission liabilityto plan participants holding unexercised stock options in California, Georgiaand possibly other states, and regulatory authorities also may require us topay fines or impose other sanctions on us.

 

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On February 16, 2005, wereceived a notice from the staff of The Nasdaq Stock Market indicating that wewere subject to potential delisting from The Nasdaq SmallCap Market for failureto comply with Nasdaq’s requirement to file our annual report on Form 10-K forthe fiscal year ended October 31, 2004 in a timely fashion.  Receipt of the notice did not result inimmediate delisting of our common stock. Nasdaq stated that, unless we requested a hearing on Nasdaq’s delistingnotice, our securities would be delisted from The Nasdaq SmallCap Market at theopening of business on February 25, 2005.

We requested a hearingwith the Nasdaq Listing Qualifications Panel on this matter, which stayed thedelisting pending the hearing and a determination by the Nasdaq ListingQualifications Panel.  The hearingoccurred on March 17, 2005.  At thehearing, we outlined for the Panel our plan for filing our Form 10-K and ourForm 10-Q for the quarter ended January 31, 2005, which also was not filed in atimely fashion.  On March 18, 2005, wereceived another notice from the staff of The Nasdaq Stock Market regarding ourpotential delisting as a result of our failure to file this Form 10-Q in atimely fashion.  The notice informed usthat the Panel would consider the filing delinquency of our Form 10-Q for thequarter ended January 31, 2005 in addition to the filing delinquency of theForm 10-K in rendering its decision regarding our listing status.  On April 1, 2005, we filed our Form 10-K, andwe filed the Form 10-Q for the quarter ended January 31, 2005 on April 14,2005.  On April 20, 2005, we receivedwritten confirmation from the Nasdaq Listing Qualifications Panel that we werein full compliance with the Nasdaq filing requirement and all otherrequirements for continued listing.

In connection with ourdetermination that certain plan participants have a right to rescind theirpurchases of shares under the Equity Compensation Plans or recover damages ifthey no longer own the shares or hold unexercised options, we determined weneeded to classify our common stock that is subject to rescission as temporaryequity.  As a result, on April 1, 2005,we filed amended quarterly reports on Form 10-Q for the quarters ended January31, 2004, April 30, 2004 and July 31, 2004 with restated condensed consolidatedfinancial statements.  In the restatedfinancial statements for each of the periods covered by the amended Form 10-Qs,we reclassified our common stock subject to rescission from permanent equity totemporary equity and made certain other changes as described in Note 2 to thefinancial statements in each of the amended Form 10-Qs.  The restatement of these financial statementsdid not impact our revenue, net loss or its earnings per share for the fiscalyear ended October 31, 2004 or our aggregate cash and available for salesecurities balances as of October 31, 2004.

**Business Focus**

Wegenerate revenue from sales of product and services from our UNIX business andfrom sales of SCOsource intellectual property (“IP”) licenses and vendorlicenses from our SCOsource business.

*UNIX Business. *Our UNIX business serves the needs ofsmall-to-medium sized businesses, including replicated site franchisees ofFortune 1000 companies, by providing reliable, cost effective UNIX operatingsystems and software products to power computers running on Intelarchitecture.  Our largest source of UNIXbusiness revenue is derived from existing customers through our worldwide,indirect, leveraged channel of partners which includes distributors andindependent solution providers.  We havea presence in a number of countries that provide support and services tocustomers and resellers.  The otherprincipal channel for selling and marketing our UNIX products is throughexisting customers that have a large number of replicated sites or franchisees.

We access these corporations through theirinformation technology or purchasing departments with our Area Sales Managers (“ASMs”)in the United States and through our reseller channel in countries outside theUnited States.  In addition, we also sellour operating 

 

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system products tooriginal equipment manufacturers (“OEMs”). Our sales of UNIX products and services during the last several periodshave been primarily to pre-existing UNIX customers and not newly acquiredcustomers.  Our UNIX business revenuedepends significantly on our ability to market and sell our products toexisting customers and to generate upgrades from existing customers.

Thefollowing table shows the operating results of the UNIX business for the threeand six months ended April 30, 2005 and 2004 (in thousands):
| ** **                    | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|-------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|                          |       |                             |       |                           |       |   |   |   |   |
| Revenue                       |       | $                                | 9,228      |                           | $          | 10,126 |   | $ | 18,023 |   | $ | 21,498 |   |
| Cost of revenue               |       | 1,309                            |       | 1,891                          |       | 2,702 |   | 4,018 |   |
| Gross margin                  |       | 7,919                            |       | 8,235                          |       | 15,321 |   | 17,480 |   |
| Sales and marketing           |       | 2,956                            |       | 4,117                          |       | 5,746 |   | 9,128 |   |
| Research and development      |       | 2,027                            |       | 2,797                          |       | 3,995 |   | 5,477 |   |
| General and administrative    |       | 1,866                            |       | 1,710                          |       | 3,538 |   | 3,882 |   |
| Other                         |       | 600                              |       | 3,577                          |       | 1,208 |   | 4,799 |   |
| Total operating expenses      |       | 7,449                            |       | 12,201                         |       | 14,487 |   | 23,286 |   |
| Income (loss) from operations |       | $                                | 470        |                           | $          | (3,966 | ) | $ | 834 |   | $ | (5,806 | ) |

 

Revenuefrom our UNIX business decreased by $898,000, or 9 percent, for the secondquarter of fiscal year 2005 compared to the second quarter of fiscal year 2004and decreased by $3,475,000, or 16 percent, for the first two quarters offiscal year 2005 compared to the first two quarters of fiscal year 2004.  The revenue from this business has beendeclining over the last several quarters primarily as a result of increasedcompetition from alternative operating systems, particularly Linux.  Ifrevenue from our UNIX business continues to decline and we are unable togenerate positive cash flow, our UNIX business will be adversely impacted.

Inan effort to attain profitability in our UNIX business, we have decreased ouroperating costs and streamlined our operations. Operating costs for our UNIX business decreased from $12,201,000 for thesecond quarter of fiscal year 2004 to $7,449,000 for the second quarter offiscal year 2005 and decreased from $23,286,000 for the first two quarters offiscal year 2004 to $14,487,000 for the first two quarters of fiscal year2005.  These cost reductions haveprimarily been attributable to reduced headcount, continued operationalefficiencies generated in our UNIX business, the elimination of certainwrite-offs and severance and exit costs, as well as from the consolidation ofcertain facilities.

Inour UNIX business, we have reduced the number of full-time equivalent employeesfrom 263 as of April 30, 2004, to 164 as of April 30, 2005.  We have taken these headcount reductions andreduced other discretionary spending while still maintaining a worldwidepresence.  Based on our cost-cuttingactions, we anticipate that our UNIX business will continue to generate incomefrom operations and positive cash flow throughout fiscal year 2005.

Thedecline in our UNIX business revenue may be accelerated if industry partnerswithdraw their support as a result of our SCOsource initiatives.  The decline in our UNIX business and ourSCOsource initiatives may cause industry partners, developers and hardware andsoftware vendors to choose not to support or certify to our UNIX operatingsystem products.  This would lead to anaccelerated decline in revenue from our UNIX business.

An important initiative for our UNIXbusiness for the 2005 fiscal year will be the release of thenext major upgrade to our OpenServer product, OpenServer 6 in June 2005.  This new 

 

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version will provideincreased system reliability, backward compatibility with existing applicationsand software, increased application and hardware support, integration withwidely used internet applications and increased system performance.  We anticipate that these enhancements willnot have a direct impact on our short-term OpenServer revenue because of thelong adoption cycle for new operating system purchases and our long operatingsystem product sales cycle, but we believe that they will help prolong ourOpenServer revenue stream for future quarters.

*SCOsourceBusiness. *During the 2003 fiscal year, we becameaware that our UNIX code and derivative works had been inappropriately includedin the Linux operating system.  Webelieve the inclusion of our UNIX code and derivative works in Linux has been amajor contributor to the decline in our UNIX business because users of Linuxgenerally do not pay for the operating system but pay only minimal fees, ifany, for service and maintenance.  TheLinux operating system competes directly with our OpenServer and UnixWareproducts and has taken significant market share from these products.

Inan effort to protect our UNIX intellectual property, weinitiated our SCOsource business.  Theinitiatives of this business include seeking to enter into license agreementswith UNIX vendors and offering SCOsource IP licenses to Linux and other endusers allowing them to continue to use our UNIX source code and derivativeworks found in Linux.  We believe thatour SCOsource licensing revenue opportunities have been adversely impacted byour outstanding dispute with Novell over our UNIX copyright ownership, whichmay have caused many potential customers to delay or forego licensing until anoutcome in this legal matter has been reached.

During fiscal year 2004,we began assigning direct resources to the SCOsource business for sales andmarketing, research and development and general and administrative.* *Thefollowing table shows the operating results of the SCOsource business for thethree and six months ended April 30, 2005 and 2004 (in thousands):
| ** **                 | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|----------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                 | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|                       |       |                             |       |                           |       |   |   |   |   |
| Revenue                    |       | $                                | 30         |                           | $          | 11 |   | $ | 100 |   | $ | 31 |   |
| Cost of revenue            |       | 2,889                            |       | 4,567                          |       | 6,382 |   | 8,090 |   |
| Gross deficit              |       | (2,859                           | )          | (4,556                         | )          | (6,282 | ) | (8,059 | ) |
| Sales and marketing        |       | 7                                |       | 581                            |       | 154 |   | 591 |   |
| Research and development   |       | 90                               |       | 71                             |       | 202 |   | 98 |   |
| General and administrative |       | 170                              |       | —                         |       | 261 |   | 22 |   |
| Other                      |       | —                           |       | —                         |       | — |   | — |   |
| Total operating expenses   |       | 267                              |       | 652                            |       | 617 |   | 711 |   |
| Loss from operations       |       | $                                | (3,126     | )                              | $          | (5,208 | ) | $ | (6,899 | ) | $ | (8,770 | ) |

 

Revenuefrom our SCOsource business increased from $11,000 in the second quarter offiscal year 2004 to $30,000 for the second quarter of fiscal year 2005 andincreased from $31,000 in the first two quarters of fiscal year 2004 to$100,000 for the first two quarters of fiscal year 2005.  Revenue in the above-mentioned periods wasprimarily attributable to sales of our SCOsource IP licenses.  Becauseof the uncertainties related to our SCOsource business, we are unable toestimate the amount and timing of future SCOsource licensing revenue.

Thisuncertainty represents a significant risk and challenge for us, both in theshort and long term.  If we do receiverevenue from this source, it may be sporadic and fluctuate from quarter toquarter.  Our SCOsource initiatives areunlikely to produce a stable or predictable 

 

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revenue stream for the foreseeable future.  We are unlikely to generate significantrevenue from our SCOsource business unless and until we prevail in ourlitigation against IBM, Red Hat, Novell, Daimler Chrysler and AutoZone (the “SCOLitigation”).  Additionally, the successof these initiatives may depend on the strength of our intellectual propertyrights and contractual claims regarding UNIX, including the strength of ourclaim that unauthorized UNIX source code and derivative works are prevalent inLinux.

Costof revenue, which primarily includes legal and professional fees incurred inconnection with the SCO Litigation, decreased from $4,567,000 in the secondquarter of fiscal year 2004 to $2,889,000 in the second quarter of fiscal year2005 and decreased from $8,090,000 in the first two quarters of fiscal year2004 to $6,382,000 in the first two quarters of fiscal year 2005.  The decrease in cost of revenue is primarilyattributable to our modified fee agreement with the law firms (the “Law Firms”)representing us in the SCO Litigation that has significantly reduced ourongoing and future operating expenses. Operating expenses for sales and marketing, research and development andgeneral and administrative decreased in the second quarter of and first twoquarters of fiscal year 2005 from the second quarter and first two quarters offiscal year 2004, which was attributable to decreased personnel and relatedcosts.

Ourfuture success with our SCOsource initiatives and future revenue from SCOsourceinitiatives will depend on our ability to protect our UNIX intellectualproperty.

**Critical Accounting Policies**

Our criticalaccounting policies and estimates include the following:

•                              Revenue recognition;

•                              Deferred income taxes and relatedvaluation allowances;

•                              Severance and exit costs;

•                              Impairment of long-lived assets; and

•                              Allowances for doubtful accounts.

*RevenueRecognition*.  We recognize revenue in accordance withStatement of Accounting Position (“SOP”) 97-2, as modified by SOP 98-9.  Revenue recognition in accordance with thesepronouncements is complex due to the nature and variability of our salestransactions.  We recognize productsrevenue upon shipment if a signed contract exists, the fee is fixed ordeterminable, collection of the resulting receivable is probable and productreturns are reasonably estimable.

Themajority of our revenue transactions relate to product-only sales.  On occasion we have revenue transactions thatinclude multiple elements (such as products, maintenance, technical supportservices and other services).  Forsoftware agreements that have multiple elements, we allocate revenue to eachcomponent of the contract based on vendor specific objective evidence (“VSOE”). VSOE is established when such elementsare sold separately.  We recognizerevenue when the criteria for product revenue recognition set forth above havebeen met.  If VSOE of all undeliveredelements exists, but VSOE does not exist for one or more delivered elements,then revenue is recognized using the residual method.  Under the residual method, the fair value ofthe undelivered elements is deferred and the remaining portion of the licensefee is recognized as revenue in the period when persuasive evidence of anarrangement is obtained assuming all other revenue recognition criteria aremet.  We recognize revenue allocated toundelivered products when the criteria for revenue recognition set forth abovehave been met.

 

26

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Estimates used inrevenue recognition include the determination of credit-worthiness of ourcustomers, verification of sales-out reporting to end users through ourtwo-tier distribution channel and the estimation of potential returns.  In addition to these estimates, we alsoprovide reserves against revenue based on historical trends andexperience.  To the extent our estimatesare incorrect, or we are not able to maintain VSOE, our recognized revenue couldbe 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.

*DeferredIncome Taxes and Related Valuation Allowance*.  The amount, and ultimate realization, of ourdeferred income tax assets depends, in part, upon the tax laws in effect, ourfuture earnings and other future events, the effects of which cannot be determined.  We have provided a valuation allowance of$66,655,000 against our entire net deferred tax asset as of October 31,2004.  The valuation allowance wasrecorded because of our history of net operating losses and the uncertaintiesregarding our future operating profitability and taxable income.

*Severanceand Exit Costs.*  Since fiscal year 2001, we have undertakensignificant restructuring activities to reduce our ongoing cost ofoperations.  All restructurings thatoccurred prior to fiscal year 2003 were accounted for in accordance withEmerging Issues Task Force (“EITF”) No. 94-3 “Liability Recognition for CertainEmployee Termination Benefits and Other Costs to Exit an Activity.”  For restructuring activities initiatedbeginning with fiscal year 2003, we have accounted for the one-time terminationbenefits, contract termination costs and other associated costs in accordancewith SFAS No. 146 “Accounting for Costs Associated with Exit or DisposalActivities.”  Other severance benefitshave been accounted for in accordance with SFAS No. 112 “Employers’ Accountingfor Postemployment Benefits.” and SFAS No. 88 “Employers’ Accounting forSettlements and Curtailments of Defined Benefit Plans and for TerminationBenefits.”

Eachrestructuring has required us to make estimates and assumptions related tolosses on vacated facilities, provisions for termination benefits, outplacementcosts and other costs.  Pursuant to therelevant accounting literature, we may record an accrual for amounts associatedwith a restructuring that are not paid in the current period.  We regularly evaluate the adequacy of theaccruals based on changes in estimates. We may incur future charges for new restructuring activities.  As of April 30, 2005, we did not have anyamounts accrued for severance and exit costs.

*Impairmentof 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.

Write-downs ofintangible assets may be necessary if the future fair value of these assets isless than carrying value.  If theoperating trends for our UNIX or SCOsource businesses continue to decline, wemay be required to record an impairment charge in a future period related tothe carrying value of our long-lived assets.

*Allowance for Doubtful Accounts*.  We offercredit terms on the sale of our products to a majority of our customers andrequire 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 lastthree fiscal years.  Our 

 

27

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allowance for doubtfulaccounts, which is determined based on our historical experience and a specificreview of customer balances, was $149,000 as of April 30, 2005.  Our past experience has resulted in minimaldifferences from the actual amounts provided for bad debts and our recordedestimates.  However, our actual bad debtsin future periods may differ from our current estimates and the differences maybe material, which may have an adverseimpact on our future accounts receivable and cash position.

**Results of Operations**

                        The following table presents ourresults of operations for the three and six months ended April 30, 2005 and2004 (in thousands):
| ** **                                          | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **Statement of Operations Data:**                   | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                |       |                             |       |                           |       |   |   |   |   |
| Revenue:                                            |       |                             |       |                           |       |   |   |   |   |
| Products                                            |       | $                                | 7,838      |                           | $          | 8,415 |   | $ | 15,142 |   | $ | 18,127 |   |
| SCOsource licensing                                 |       | 30                               |       | 11                             |       | 100 |   | 31 |   |
| Services                                            |       | 1,390                            |       | 1,711                          |       | 2,881 |   | 3,371 |   |
| Total revenue                                       |       | 9,258                            |       | 10,137                         |       | 18,123 |   | 21,529 |   |
| Cost of revenue:                                    |       |                             |       |                           |       |   |   |   |   |
| Products                                            |       | 563                              |       | 818                            |       | 1,207 |   | 1,623 |   |
| SCOsource licensing                                 |       | 2,889                            |       | 4,567                          |       | 6,382 |   | 8,090 |   |
| Services                                            |       | 746                              |       | 1,073                          |       | 1,495 |   | 2,395 |   |
| Total cost of revenue                               |       | 4,198                            |       | 6,458                          |       | 9,084 |   | 12,108 |   |
| Gross margin                                        |       | 5,060                            |       | 3,679                          |       | 9,039 |   | 9,421 |   |
| Operating expenses:                                 |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                                 |       | 2,963                            |       | 4,698                          |       | 5,900 |   | 9,719 |   |
| Research and development                            |       | 2,117                            |       | 2,868                          |       | 4,197 |   | 5,575 |   |
| General and administrative                          |       | 2,036                            |       | 1,710                          |       | 3,799 |   | 3,904 |   |
| Loss on disposition of long-lived assets            |       | —                           |       | 2,139                          |       | — |   | 2,139 |   |
| Severance and exit costs                            |       | —                           |       | 682                            |       | — |   | 682 |   |
| Amortization of intangibles                         |       | 593                              |       | 593                            |       | 1,186 |   | 1,380 |   |
| Stock-based compensation                            |       | 7                                |       | 163                            |       | 22 |   | 598 |   |
| Total operating expenses                            |       | 7,716                            |       | 12,853                         |       | 15,104 |   | 23,997 |   |
| Loss from operations                                |       | (2,656                           | )          | (9,174                         | )          | (6,065 | ) | (14,576 | ) |
| Equity in income of affiliate                       |       | 17                               |       | 37                             |       | 70 |   | 74 |   |
| Other income, net                                   |       | 800                              |       | 2,422                          |       | 1,309 |   | 6,185 |   |
| Provision for income taxes                          |       | (123                             | )          | (966                           | )          | (237 | ) | (1,094 | ) |
| Net loss                                            |       | (1,962                           | )          | (7,681                         | )          | (4,923 | ) | (9,411 | ) |
| Dividends on redeemable convertible preferred stock |       | —                           |       | (7,045                         | )          | — |   | (7,801 | ) |
| Net loss applicable to common stockholders          |       | $                                | (1,962     | )                              | $          | (14,726 | ) | $ | (4,923 | ) | $ | (17,212 | ) |

 

28

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**THREEAND SIX MONTHS ENDED APRIL 30, 2005 AND 2004**

### ***Revenue***

| ** ** | ** ** | **Three Months Ended April 30,** | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|       |       |                             |       |   |   |   |   |
| Revenue    |       | $                                | 9,258,000  |   | (9 | )% | $ | 10,137,000 |   |
|            |            |                                  |            |  |  |  |  |  |  |

 
| ** ** | ** ** | **Six Months Ended April 30,** | ** ** |
|------------|------------|--------------------------------|------------|
| ** ** | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|       |       |                           |       |   |   |   |   |
| Revenue    |       | $                              | 18,123,000 |   | (16 | )% | $ | 21,529,000 |   |
|            |            |                                |            |  |  |  |  |  |  |

 

Revenuefor the second quarter of fiscal year 2005 decreased by $879,000, or 9 percent,from the second quarter of fiscal year 2004, and revenue for the first twoquarters of fiscal year 2005 decreased by $3,406,000, or 16 percent, from thefirst two quarters of fiscal year 2004. These decreases were primarily attributable to a continued decline inour UNIX business.

Revenuegenerated from our UNIX business and SCOsource business is as follows:
| ** **               | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                     |       |                             |       |   |   |   |   |
| UNIX revenue             |       | $                                | 9,228,000  |   | (9 | )% | $ | 10,126,000 |   |
| Percent of total revenue |       | 100                              | %          |   |   | 100 | % |
| SCOsource revenue        |       | 30,000                           |       | 173 | % | 11,000 |   |
| Percent of total revenue |       | 0                                | %          |   |   | 0 | % |
|                          |            |                                  |            |  |  |  |  |  |  |

 
| ** **               | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                     |       |                           |       |   |   |   |   |
| UNIX revenue             |       | $                              | 18,023,000 |   | (16 | )% | $ | 21,498,000 |   |
| Percent of total revenue |       | 99                             | %          |   |   | 100 | % |
| SCOsource revenue        |       | 100,000                        |       | 223 | % | 31,000 |   |
| Percent of total revenue |       | 1                              | %          |   |   | 0 | % |
|                          |            |                                |            |  |  |  |  |  |  |

 

Thedecrease in revenue in the UNIX business of $898,000 for the second quarter offiscal year 2005 compared to the second quarter of fiscal year 2004 and thedecrease in UNIX revenue of $3,475,000 for the first two quarters of fiscalyear 2005 compared to the first two quarters of fiscal year 2004 was primarilyattributable to continued competition from other operating systems,particularly Linux.  We anticipate thatfor the remainder of fiscal year 2005 our UNIX business and the related revenuefrom the UNIX business will face significant competition from Linux and otheroperating systems.  The increase inSCOsource revenue for the second quarter and first two quarters of fiscal year2005 compared to the second quarter and first two quarters of fiscal year 2004was primarily attributable to increased sales of SCO IP licenses.

Salesof our UNIX products and services during the second quarter and first twoquarters of fiscal year 2005 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 

 

29

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certificationsupport or direct their support to our competitors.  This may occur as a result of the decline ofour UNIX business and our SCOsource initiatives.

*Products Revenue*
| ** **               | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                     |       |                             |       |   |   |   |   |
| Products revenue         |       | $                                | 7,838,000  |   | (7 | )% | $ | 8,415,000 |   |
| Percent of total revenue |       | 85                               | %          |   |   | 83 | % |
|                          |            |                                  |            |  |  |  |  |  |  |

 
| ** **               | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                     |       |                           |       |   |   |   |   |
| Products revenue         |       | $                              | 15,142,000 |   | (16 | )% | $ | 18,127,000 |   |
| Percent of total revenue |       | 84                             | %          |   |   | 84 | % |
|                          |            |                                |            |  |  |  |  |  |  |

 

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

Thedecrease in products revenue of $577,000 from the second quarter of fiscal year2005 compared to the second quarter of fiscal year 2004 and the decrease of$2,985,000 from the first two quarters of fiscal year 2005 compared to thefirst two quarters of fiscal year 2004 was primarily attributable todecreased sales of OpenServer and UnixWare products primarily resulting fromincreased competition in the operating system market, particularly Linux.  We believe that this competition from Linuxwill continue for the remainder of fiscal year 2005 and future periods.

Ourproducts revenue was derived primarily from sales of our OpenServer andUnixWare products.  Other productsrevenue consists mainly of product maintenance and other UNIX-related products.  Revenue for these products was as follows:
| ** **                  | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                             |       |   |   |   |   |
| OpenServer revenue          |       | $                                | 4,664,000  |   | 2 | % | $ | 4,580,000 |   |
| Percent of products revenue |       | 60                               | %          |   |   | 54 | % |
| UnixWare revenue            |       | 2,391,000                        |       | (1 | )% | 2,425,000 |   |
| Percent of products revenue |       | 30                               | %          |   |   | 29 | % |
| Other products revenue      |       | 783,000                          |       | (44 | )% | 1,410,000 |   |
| Percent of products revenue |       | 10                               | %          |   |   | 17 | % |
|                             |            |                                  |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                           |       |   |   |   |   |
| OpenServer revenue          |       | $                              | 8,677,000  |   | (11 | )% | $ | 9,782,000 |   |
| Percent of products revenue |       | 57                             | %          |   |   | 54 | % |
| UnixWare revenue            |       | 4,527,000                      |       | (12 | )% | 5,163,000 |   |
| Percent of products revenue |       | 30                             | %          |   |   | 28 | % |
| Other products revenue      |       | 1,938,000                      |       | (39 | )% | 3,182,000 |   |
| Percent of products revenue |       | 13                             | %          |   |   | 18 | % |
|                             |            |                                |            |  |  |  |  |  |  |

 

30

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OpenServerand UnixWare revenue for the second quarter of fiscal year 2005 was essentiallyflat as compared to the second quarter of fiscal year 2004.  The decrease in other products revenue forthe second quarter of fiscal year 2005 compared to the second quarter of fiscalyear 2004 was primarily attributable to decreased product maintenance sales.

Thedecreases in revenue for the first two quarters of fiscal year 2005 as comparedto the first two quarters of fiscal year 2004 for OpenServer, UnixWare andother products are all primarily the result of continued competition from otheroperating systems, particularly Linux.

*SCOsourceLicensing Revenue*
| ** **                  | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                             |       |   |   |   |   |
| SCOsource licensing revenue |       | $                                | 30,000     |   | 173 | % | $ | 11,000 |   |
| Percent of total revenue    |       | 0                                | %          |   |   | 0 | % |
|                             |            |                                  |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                           |       |   |   |   |   |
| SCOsource licensing revenue |       | $                              | 100,000    |   | 223 | % | $ | 31,000 |   |
| Percent of total revenue    |       | 1                              | %          |   |   | 0 | % |
|                             |            |                                |            |  |  |  |  |  |  |

 

Weinitiated our SCOsource business for the purpose of protecting our intellectualproperty rights in our UNIX source code and derivative works.  SCOsource licensing revenue was $30,000 inthe second quarter of fiscal year 2005 compared to revenue of $11,000 generatedin the second quarter of fiscal year 2004. SCOsource licensing revenue was $100,000 in the first two quarters offiscal year 2005 compared to revenue of $31,000 in the first two quarters offiscal year 2004.  Our SCOsourcelicensing revenue was primarily generated from the sales of SCO IP licenses.

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

*Services Revenue*
| ** **               | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                     |       |                             |       |   |   |   |   |
| Services revenue         |       | $                                | 1,390,000  |   | (19 | )% | $ | 1,711,000 |   |
| Percent of total revenue |       | 15                               | %          |   |   | 17 | % |
|                          |            |                                  |            |  |  |  |  |  |  |

 
| ** **               | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                     |       |                           |       |   |   |   |   |
| Services revenue         |       | $                              | 2,881,000  |   | (15 | )% | $ | 3,371,000 |   |
| Percent of total revenue |       | 16                             | %          |   |   | 16 | % |
|                          |            |                                |            |  |  |  |  |  |  |

 

Servicesrevenue consists primarily of annual and incident technical support fees,engineering services fees, professional services and consulting fees, andeducation fees.  These fees are typicallycharged and invoiced separately from UNIX products sales.  The decrease in services revenue of $321,000,or 19 percent, from the second quarter of fiscal year 2004 as compared to thesecond quarter of fiscal year 2005 and the decrease in services revenue of$490,000, or 15 percent, from the first two quarters of fiscal year 2004 ascompared to the first two quarters of fiscal year 2005, was in part due to thedecrease in products revenue, fewer customers renewing services agreements anda decrease in professional services revenue.

 

31

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

*Cost of Products Revenue*
| ** **                     | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                           |       |                             |       |   |   |   |   |
| Cost of products revenue       |       | $                                | 563,000    |   | (31 | )% | $ | 818,000 |   |
| Percentage of products revenue |       | 7                                | %          |   |   | 10 | % |
|                                |            |                                  |            |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                           |       |                           |       |   |   |   |   |
| Cost of products revenue       |       | $                              | 1,207,000  |   | (26 | )% | $ | 1,623,000 |   |
| Percentage of products revenue |       | 8                              | %          |   |   | 9 | % |
|                                |            |                                |            |  |  |  |  |  |  |

 

Costof products revenue consists of manufacturing costs, royalties to third-partyvendors, technology costs and overhead costs. Cost of products revenue decreased by $255,000, or 31 percent, in thesecond quarter of fiscal year 2005 as compared to the second quarter of fiscalyear 2004 and decreased by $416,000, or 26 percent, in the first two quartersof fiscal year 2005 compared to the first two quarters of fiscal year2004.  This decrease in the dollar amountof cost of products revenue was primarily attributable to lower productsrevenue, lower manufacturing costs, decreased royalties to third party vendorsand lower amortized technology costs.

Forthe remaining quarters of fiscal year 2005, we expect the dollar amount of ourcost of products revenue to be generally consistent with cost of productsrevenue incurred in the second quarter of fiscal year 2005 and that cost ofproducts revenue as a percentage of products revenue for the remaining quartersof fiscal year 2005 will be generally consistent to that incurred in the secondquarter of fiscal year 2005.

*Cost of SCOsourceLicensing Revenue*  
| ** **                                | ** ** | **Three Months Ended April 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                                      |       |                             |       |   |   |   |   |
| Cost of SCOsource licensing revenue       |       | $                                | 2,889,000  |   | (37 | )% | $ | 4,567,000 |   |
| Percentage of SCOsource licensing revenue |       | 9630                             | %          |   |   | 41518 | % |
|                                           |            |                                  |            |  |  |  |  |  |  |

 
| ** **                                | ** ** | **Six Months Ended April 30,** | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                                      |       |                           |       |   |   |   |   |
| Cost of SCOsource licensing revenue       |       | $                              | 6,382,000  |   | (21 | )% | $ | 8,090,000 |   |
| Percentage of SCOsource licensing revenue |       | 6382                           | %          |   |   | 26097 | % |
|                                           |            |                                |            |  |  |  |  |  |  |

 

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

Costof SCOsource licensing revenue decreased by $1,678,000, or 37 percent, duringthe second quarter of fiscal year 2005 as compared to the second quarter offiscal year 2004 and decreased by $1,708,000, or 21 percent, during the firsttwo quarters of fiscal year 2005 as compared to the first two quarters offiscal year 2004.  The decrease in costsin the second quarter of fiscal year 2005 compared to the second quarter offiscal year 2004 was primarily attributable to 

 

32

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decreasedlegal costs incurred in connection with our SCO Litigation as a result of ourEngagement Agreement.

According to the terms of our Engagement Agreementwith the Law Firms described in more detail below in this Item 2 of Part I ofthis Form 10-Q, we anticipate that the dollar amount of our cost of SCOsourcelicensing for the remaining quarters of fiscal year 2005 will be generallyconsistent with the costs incurred in the first and second quarters of fiscalyear 2005.  However, future legal fees mayinclude contingency payments made to the Law Firms as a result of a settlement,judgment, certain licensing fees or a sale of our company, which could causecost of SCOsource licensing revenue to be higher than anticipated.

*Cost of Services Revenue*
| ** **                     | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                           |       |                             |       |   |   |   |   |
| Cost of services revenue       |       | $                                | 746,000    |   | (30 | )% | $ | 1,073,000 |   |
| Percentage of services revenue |       | 54                               | %          |   |   | 63 | % |
|                                |            |                                  |            |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                           |       |                           |       |   |   |   |   |
| Cost of services revenue       |       | $                              | 1,495,000  |   | (38 | )% | $ | 2,395,000 |   |
| Percentage of services revenue |       | 52                             | %          |   |   | 71 | % |
|                                |            |                                |            |  |  |  |  |  |  |

 

Costof services revenue includes the salaries and related personnel costs ofemployees delivering services revenue as well as third-party serviceagreements.  Cost of services revenuedecreased by $327,000, or 30 percent, for the second quarter of fiscal year 2005compared to the second quarter of fiscal year 2004 and decreased by $900,000,or 38 percent, for the first two quarters of fiscal year 2005 compared to thefirst two quarters of fiscal year 2004. This decrease was primarily attributable to reduced employee andrelated costs.

Forthe remaining quarters of fiscal year 2005, we expect the dollar amount of ourcost of services revenue to be generally consistent to cost of services revenueincurred in the second quarter of fiscal year 2005 and that cost of servicesrevenue as a percentage of services revenue for the remaining quarters offiscal year 2005 will be generally consistent to that incurred in the secondquarter of fiscal year 2005.

*Sales and Marketing*
| ** **                  | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                             |       |   |   |   |   |
| Sales and marketing expense |       | $                                | 2,963,000  |   | (37 | )% | $ | 4,698,000 |   |
| Percentage of total revenue |       | 32                               | %          |   |   | 46 | % |
|                             |            |                                  |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                           |       |   |   |   |   |
| Sales and marketing expense |       | $                              | 5,900,000  |   | (39 | )% | $ | 9,719,000 |   |
| Percentage of total revenue |       | 33                             | %          |   |   | 45 | % |
|                             |            |                                |            |  |  |  |  |  |  |

 

Salesand marketing expenses primarily consist of the salaries, commissions and otherpersonnel costs of employees involved in the revenue generation process, aswell as advertising and corporate allocations.  The decrease in sales and marketing expense of$1,735,000, or 37 percent, from the second quarter of fiscal year 2004 comparedto the second quarter of fiscal year 

 

33

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2005and the decrease of $3,819,000, or 39 percent, from the first two quarters offiscal year 2004 compared to the first two quarters of fiscal year 2005 wasprimarily attributable to reductions in sales and marketing employees, reducedtravel expenses, less commissions and lower advertising costs.  Our sales and marketing full-time equivalentemployees decreased from 82 as of April 30, 2004 to 52 as of April 30, 2005.

Forthe remaining quarters of fiscal year 2005, we anticipate that the dollaramount of sales and marketing expense will be generally consistent to thatincurred in the second quarter of fiscal year 2005.

*Research and Development*
| ** **                       | ** ** | **Three Months Ended April 30,** | ** ** |
|----------------------------------|------------|----------------------------------|------------|
| ** **                       | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                             |       |                             |       |   |   |   |   |
| Research and development expense |       | $                                | 2,117,000  |   | (26 | )% | $ | 2,868,000 |   |
| Percentage of total revenue      |       | 23                               | %          |   |   | 28 | % |
|                                  |            |                                  |            |  |  |  |  |  |  |

 
| ** **                       | ** ** | **Six Months Ended April 30,** | ** ** |
|----------------------------------|------------|--------------------------------|------------|
| ** **                       | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                             |       |                           |       |   |   |   |   |
| Research and development expense |       | $                              | 4,197,000  |   | (25 | )% | $ | 5,575,000 |   |
| Percentage of total revenue      |       | 23                             | %          |   |   | 26 | % |
|                                  |            |                                |            |  |  |  |  |  |  |

 

Researchand development expenses primarily consist of the salaries and benefits ofsoftware engineers, consulting expenses and corporate allocations.  Research and development expense decreased by$751,000, or 26 percent, from the second quarter of fiscal year 2005 comparedto the second quarter of fiscal year 2004 and decreased by $1,378,000, or 25percent, from the first two quarters of fiscal year 2005 compared to the firsttwo quarters of fiscal year 2004 and was primarily attributable to work forcereductions.  Our research and developmentfull-time equivalent employees decreased from 85 as of April 30, 2004 to 52 asof April 30, 2005.

Forthe remaining quarters of fiscal year 2005, we anticipate that the dollaramount of research and development expense will be generally consistent to thatincurred in the second quarter of fiscal year 2005.

*General and Administrative*
| ** **                         | ** ** | **Three Months Ended April 30,** | ** ** |
|------------------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                               |       |                             |       |   |   |   |   |
| General and administrative expense |       | $                                | 2,036,000  |   | 19 | % | $ | 1,710,000 |   |
| Percentage of total revenue        |       | 22                               | %          |   |   | 17 | % |
|                                    |            |                                  |            |  |  |  |  |  |  |

 
| ** **                         | ** ** | **Six Months Ended April 30,** | ** ** |
|------------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                               |       |                           |       |   |   |   |   |
| General and administrative expense |       | $                              | 3,799,000  |   | (3 | )% | $ | 3,904,000 |   |
| Percentage of total revenue        |       | 21                             | %          |   |   | 18 | % |
|                                    |            |                                |            |  |  |  |  |  |  |

 

Generaland administrative expenses primarily consist of the salaries and benefits offinance, human resources, and executive management and expenses forprofessional services such as legal and accounting and corporateallocations.  General and administrativeexpense increased by $326,000, or 19 percent, during the second quarter of fiscalyear 2005 as compared to the second quarter of fiscal year 2004 and decreasedby $105,000, or 3 percent, during the first two quarters of fiscal year 2005 ascompared to the first two quarters of fiscal year 2004.  The increase 

 

34

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ingeneral and administrative expense during the second quarter of fiscal year2005 compared to the second quarter of fiscal year 2004 was primarilyattributable to legal and accounting costs incurred in connection with therestatement of our 2004 quarterly financial statements.  The decrease in general and administrativeexpense for the first two quarters of fiscal year 2005 compared to the firsttwo quarters of fiscal year 2004 was primarily attributable to lower personneland related costs offset by the increased costs related to the restatementmentioned above.  Our general andadministrative full-time equivalent employees decreased from 54 as of April 30,2004 to 29 as of April 30, 2005.

Forthe remaining quarters of fiscal year 2005, we anticipate that the dollaramount of general and administrative expenses will be generally consistent tothat incurred in the first quarter of fiscal year 2005 as the second quartercontained non-recurring costs related to the restatement of our 2004 quarterlyfinancial statements.  However, due tothe new compliance and reporting regulations under the Sarbanes-Oxley Act andother new regulatory requirements, general and administrative expenses may varyas we implement policies and procedures to comply with these new requirements.

*Loss on Impairment of Long-lived Assets*

Werecorded a loss on impairment of long-lived assets totaling $2,139,000 for thesecond quarter and first two quarters of fiscal year 2004.  The impairment related to goodwill andintangible assets acquired in connection with our acquisition of Vultus, Inc. (“Vultus”)in June 2003.  We 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. Consequently, we concluded that no significant future cash flows relatedto our Vultus assets will be realized. We performed an impairment analysis of our recorded goodwill related tothe Vultus reporting unit in accordance with SFAS No. 142.  Additionally, an impairment analysis of theintangible assets was performed in accordance with SFAS No. 144.  As a result of these analyses, we wrote-downthe carrying value of our goodwill related to our Vultus acquisition from$1,166,000 to $0, and wrote-down the intangible assets related to our Vultusacquisition from $973,000 to $0.

Wedid not incur any impairment charges in the second quarter or first twoquarters of fiscal year 2005.

*Severance and Exit Costs*

Severance and exit costs were $0 and $682,000 forthe second and first two quarters of fiscal year 2005 and 2004,respectively.  The costs incurred in suchperiods of fiscal year 2004 were primarily attributable to headcount reductions.

The following table shows the activityrelated to the accrual for severance and exit costs for the first two quartersof fiscal year 2005 (in thousands): 
| ** **                  | ** ** | **Balance at**

**November 1, 2004** | ** ** | **Additions** | ** ** | **Payments** | ** ** | **Balance at**

**April 30, 2005** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|---------------|------------|--------------|------------|------------------------------------|------------|
|                        |       |                                 |       |          |       |         |       |                               |       |
| Ongoing severance and other |       | $                                    | 401        |          | $          | —       |       | $                                  | (401       | ) | $ | — |   |
|                             |            |                                      |            |               |            |              |            |                                    |            |  |  |  |  |

 

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*Amortization of Intangibles*
| ** **                  | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                             |       |   |   |   |   |
| Amortization of intangibles |       | $                                | 593,000    |   | 0 | % | $ | 593,000 |   |
| Percentage of total revenue |       | 6                                | %          |   |   | 6 | % |
|                             |            |                                  |            |  |  |  |  |  |  |

* *
| ** **                  | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2005**                       | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                           |       |   |   |   |   |
| Amortization of intangibles |       | $                              | 1,186,000  |   | (14 | )% | $ | 1,380,000 |   |
| Percentage of total revenue |       | 7                              | %          |   |   | 6 | % |
|                             |            |                                |            |  |  |  |  |  |  |

 

During the second quarterof fiscal years 2005 and 2004, we recorded $593,000 for the amortization ofintangible assets with finite lives.  Forthe first two quarters of fiscal years 2005 and 2004, we recorded $1,186,000and $1,380,000, respectively, in amortization. The decrease of $194,000, or 14 percent, from the first two quarters offiscal year 2005 compared to the first two quarters of fiscal year 2004 wasprimarily attributable to reduced amortization expense recorded on certainassets acquired from Vultus in June 2003 that were written down to $0 duringfiscal year 2004.

*Stock-based Compensation*
| ** **                  | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2005**                         | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                             |       |   |   |   |   |
| Stock-based compensation    |       | $                                | 7,000      |   | (96 | )% | $ | 163,000 |   |
| Percentage of total revenue |       | 0                                | %          |   |   | 2 | % |
|                             |            |                                  |            |  |  |  |  |  |  |

* *
| ** **                  | ** ** | **Six Months Ended April 30** | ** ** |
|-----------------------------|------------|-------------------------------|------------|
| ** **                  | ** ** | **2005**                      | ** ** | **Change** | ** ** | **2004** | ** ** |
|                        |       |                          |       |   |   |   |   |
| Stock-based compensation    |       | $                             | 22,000     |   | (96 | )% | $ | 598,000 |   |
| Percentage of total revenue |       | 0                             | %          |   |   | 3 | % |
|                             |            |                               |            |  |  |  |  |  |  |

 

Stock-basedcompensation consisted of the following components for the second and first twoquarters of fiscal years 2005 and 2004 (in thousands):
| ** **                                | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                      |       |                             |       |                           |       |   |   |   |   |
| Amortization of stock-based compensation  |       | $                                | 7          |                           | $          | 113 |   | $ | 22 |   | $ | 223 |   |
| Options, warrants and shares for services |       | —                           |       | 50                             |       | — |   | 283 |   |
| Modifications to options                  |       | —                           |       | —                         |       | — |   | 92 |   |
| Total                                     |       | $                                | 7          |                           | $          | 163 |   | $ | 22 |   | $ | 598 |   |

 

Asof April 30, 2005, we had amortized all amounts related to deferredcompensation.

*Equityin Income (Losses) of Affiliate*

Weaccount for our ownership interests in companies in which 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 consolidated statementsof 

 

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operations. As of April 30, 2005, the carrying value of our investments was relatedto our 30 percent ownership in a Chinese company.

Duringthe second quarter of fiscal years 2005 and 2004, we recorded $17,000 and$37,000, respectively, that related to equity in income of this entity, andduring the first two quarters of fiscal years 2005 and 2004, we recorded$70,000 and $74,000, respectively.

*OtherIncome (Expense), net*

Otherincome (expense), net consisted of the following components for the second andfirst two quarters of fiscal years 2005 and 2004 (in thousands):
| ** **                         | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|                               |       |                             |       |                           |       |   |   |   |   |
| Interest income                    |       | $                                | 98         |                           | $          | 242 |   | $ | 135 |   | $ | 512 |   |
| Change in fair value of derivative |       | —                           |       | 2,300                          |       | — |   | 5,924 |   |
| Other income (expense), net        |       | 702                              |       | (120                           | )          | 1,174 |   | (251 | ) |
| Total                              |       | $                                | 800        |                           | $          | 2,422 |   | $ | 1,309 |   | $ | 6,185 |   |

 

Interestincome decreased by $144,000 from the second quarter of fiscal year 2004 to thesecond quarter of fiscal year 2005 and decreased by $377,000 from the first twoquarters of fiscal year 2004 to the first two quarters of fiscal year 2005 andwas primarily attributable to a decrease in our cash and available-for-salesecurities balances.

Theincome recorded on the change in fair value of derivative for the second andfirst two quarters of fiscal year 2004 relatedto the decrease in fair value of this instrument and marking it to market ateach balance sheet date.  Thederivative financial instrument was eliminated during the second quarter offiscal year 2004.

Theincrease in other income (expense), net, for the first two quarters of fiscalyear 2005 compared to the first two quarters of fiscal year 2004 was primarilyattributable to two items: 1) the collection of a note receivable from Vintela,Inc. (“Vintela”) as described in more detail in Note 9 to our financialstatements above in Part I, Item 1 of this Form 10-Q, which  note receivable was originally received inApril 2003, but because we received the note receivable in exchange for thetransfer of certain software to a related party and there was substantial doubtconcerning the ability of Vintela to repay the note, no gain was recognizeduntil the first quarter of fiscal year 2005 when we received payment; and 2)the sale of shares we held in Troll Tech AS (“Troll Tech”) as described in moredetail in Note 4 to our financial statements above in Part I, Item 1 of thisForm 10-Q.  The Troll Tech shares hadbeen written off in fiscal year 2001, but because they were sold during thesecond quarter of fiscal year 2005, we recorded income on the proceedsreceived.

*Provision for Income Taxes*

The provision for income taxes was $123,000 in thesecond quarter of fiscal year 2005 and $966,000 in the second quarter of fiscalyear 2004.  The provision for incometaxes was $237,000 in the first two quarters of fiscal year 2005 and $1,094,000in the first two quarters of fiscal year 2004. Our provision for incometaxes is primarily related to earnings in foreign subsidiaries and withholdingtaxes on revenue generated in certain locations.  The decrease in the provision for incometaxes for both the second quarter and first two quarters of fiscal year 2005 ascompared to the second quarter and first two quarters of fiscal year 2004 isattributable to an accrual for withholding taxes of $710,000 that was made inthe second quarter of fiscal year 2004 which taxes were estimated to be paid in connection with the operations of the Indianbranch of our United Kingdom subsidiary, SCO Group, Ltd.

 

37

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### ***DividendsRelated to Series A Convertible Preferred****Stock*

We had no dividends ineither the second quarter or first two quarters of fiscal year 2005.

### **In connection with completing theFebruary 5, 2004 exchange of all the then outstanding shares of Series AConvertible Preferred Stock for shares of our Series A-1 Convertible PreferredStock, we removed the carrying value of the Series A shares and relatedderivative and recorded the fair value of the Series A-1 shares issued in theexchange transaction.  The differencebetween these two amounts was $6,305,000 and was recorded as a non-cashdividend for the second quarter and first two quarters of fiscal year 2004.**

### **Additionally, with respect to theSeries A-1 shares,**weaccrued dividends of $740,000 for the second quarter of fiscal year 2004 and$1,496,000 in dividends for the first two quarters of fiscal year 2004, werepurchased all outstanding Series A-1 shares in July 2004.

**Liquidityand Capital Resources**

During the six monthsended April 30, 2005, we used cash of $17,702,000 in our operations.  The majority of this cash was used to payaccounts payable, accrued liabilities and ongoing expenses related to our SCOLitigation.  As of April 30, 2005, wehave a total of $14,192,000 in cash and cash equivalents and available-for-salesecurities and an additional $7,974,000 in restricted cash, of which $3,967,000is designated to be used as payments for experts, consultants and otherexpenses in the SCO Litigation.  As aresult of the Engagement Agreement between us and the Law Firms, we anticipateusing cash of approximately $7,000,000 in the defense of our SCO Litigationduring the remainder of the year ending October 31, 2005, which would leave usapproximately $11,159,000 in cash for our business operations as of October 31,2005.  We expect that our UNIX businesswill generate sufficient cash in the year ending October 31, 2005 to cover ourinternal costs for our SCOsource initiatives and the SCO Litigation, and webelieve we will have sufficient cash resources to fund our operations throughOctober 31, 2005.

In the event that cashrequired to fund operations and strategic initiatives exceeds our current cashresources and cash generated from operations, we will be required to reducecosts and perhaps raise additional capital. We may not be able to reduce costs in a manner that does not impair ourability to maintain our UNIX business and pursue our SCOsourceinitiatives.  We may also not be able toraise capital for any number of reasons including those listed under thesection “Risk Factors” below.  Ifadditional equity financing is available, it may not be available to us onattractive terms and may be dilutive to our existing stockholders.  In addition, if our stock price declines, wemay not be able to access the public equity markets on acceptable terms, if atall.  Our ability to effect acquisitionsfor stock would also be impaired.

Ourcash and equivalents balance decreased from $12,693,000 as of October 31, 2004to $8,145,000 as of April 30, 2005. During this same time period, our investment in available-for-salesecurities decreased from $18,756,000 to $6,047,000.  Total cash and equivalents and available-forsale securities were $14,192,000 as of April 30, 2005.  We also have $3,967,000 classified as acomponent of restricted cash set aside to cover expert, consulting and otherexpenses related to our SCO Litigation. During the first two quarters of fiscal year 2005, we expended asignificant amount of cash to pay accounts payable, accrued liabilities andongoing legal costs related to our intellectual property litigation.  We intend to use the cash and equivalents andavailable-for-sale securities as of April 30, 2005 to maintain our UNIXbusiness and pursue our SCO Litigation.

Ournet cash used in operations during the first two quarters of fiscal year 2005was $17,702,000 and was attributable to a net loss of $4,923,000, non-cashitems of $1,521,000 and changes in operating assets and liabilities of$14,300,000.  Our working capitaldecreased from 

 

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$15,413,000as of October 31, 2004 to $12,489,000 as of April 30, 2005 and was primarilyattributable to payments made to the Law Firms for the SCO Litigation.

Ournet cash used in operations during the first two quarters of fiscal year 2004was $5,206,000.  Cash used in operationswas attributable to a net loss of $9,411,000, non-cash expenses of $1,280,000and from changes in operating assets and liabilities of $5,485,000.

Our investing activitieshave historically consisted of equipment purchases, investing in strategicpartners and the purchase and sale of available-for-sale securities.  During the first two quarters of fiscal year2005, cash provided by investing activities was $12,564,000, which wasprimarily a result of sales, net of purchases, of available-for-sale securitiesof $12,709,000, which amount was offset by purchases of equipment of $145,000.

During the first twoquarters of fiscal year 2004, cash used in investing activities was$36,604,000, which was primarily a result of our purchase of available-for-salesecurities, net of sales, of $36,209,000, equipment purchases of $186,000, andthe purchase of the remaining minority interest in our Japanese subsidiary of$209,000.

Our financing activitiesprovided $578,000 of cash in the first two quarters of fiscal year 2005.  The primary sources of cash were from theexercise of options to acquire common stock of $205,000 and proceeds of$373,000 received from the sale of common stock through our ESPP.

Our financing activitiesused $1,697,000 during the first two quarters of fiscal year 2004 and consistedprimarily of cash used to purchase shares of our common stock on the openmarket of $2,414,000 and cash used to exchange Series A-1 for Series A sharesof $212,000.  These uses of cash wereoffset from proceeds received from the exercise of stock options of $559,000and proceeds from the purchase of shares of common stock by our employeesthrough our employee stock purchase program of $370,000.

Our net accountsreceivable balance decreased from $6,638,000 as of October 31, 2004 to$6,325,000 as of April 30, 2005, primarily as a result of lower invoicing andrevenue in the second quarter of fiscal year 2005 as compared to the fourthquarter of fiscal year 2004.  Themajority of our accounts receivable are current and our allowance for doubtfulaccounts was $149,000 as of April 30, 2005, which represented approximately 2percent of our gross accounts receivable balance.  This percentage of gross accounts receivableis consistent with our experience in prior periods, and we expect this trend tocontinue.  Our write-offs ofuncollectible accounts during the first two quarters of fiscal year 2005 werenot significant.

OnOctober 31, 2004, we entered into the Engagement Agreement with the LawFirms.  The Engagement Agreement governsthe relationship between us and the Law Firms in connection with theirrepresentation of us in the SCO Litigation, through the end of the currentlitigation between us and IBM.  Ourpurpose in entering into this Engagement Agreement was to limit the cashexpenditures needed to pursue the SCO Litigation.  The Engagement Agreement provides for thepayment of approximately $26,000,000 for attorney fees in connection with theSCO Litigation through the end of the current litigation between us and IBM andthe escrow of at least $5,000,000 for the payment of any expert, consulting andother expenses.  As of April 30, 2005, wehad paid $1,033,000 of expenses and the remaining $3,967,000 was classified asa component of restricted cash.

Forfuture legal fees, the Engagement Agreement requires us to pay to the Law Firms$2,000,000 per quarter for each successive quarter which began September 1,2004 and will end December 1, 2005 for a total amount of $12,000,000.  In the first two quarters of fiscal year2005, we made the quarterly payments for September 2004, December 2004 andMarch 2005 for a total 

 

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of $6,000,000. The payment of these fees has had and will continue to have a materialimpact on our cash position.

Inaddition to the cash expenditures mentioned above, we must also pay one or morecontingency fees upon any amount we or our stockholders may receive as arecovery from our litigation, our intellectual property licensing or a sale ofour company.  The contingency fee amountspayable to the Law Firms will be, subject to certain credits and adjustments, asfollows:

•                  33 percent of any aggregate recoveryamounts received up to $350,000,000;

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

•                  plus 20 percent of any aggregate recoveryamounts in excess of $700,000,000.

TheEngagement Agreement specifically provides that, except for the compensationobligations specifically described above, we will not be obligated to pay anylegal fees, whether hourly, contingent or otherwise, to the Law Firms, or anyother law firms that may be engaged by the Law Firms, in connection with theSCO Litigation through the end of the current litigation between us and IBM,including any appeals.

Wehave entered into operating leases for our corporate offices located in theUnited States and our international sales offices.  We have commitments under these leases thatextend through fiscal year 2010.

Thefollowing table summarizes our contractual operating lease obligations and ourrequired payments to the Law Firms as of April 30, 2005:  

| ** **                  | ** ** | **Total** | ** ** | **Less than**

**1 year** | ** ** | **1 — 3 years** | ** ** | **More than**

**3 years** | ** ** |
|-----------------------------|------------|-----------|------------|---------------------------|------------|----------------------|------------|----------------------------|------------|
|                        |       |      |       |                      |       |                 |       |                       |       |
| Operating lease obligations |       | $         | 3,506,000  |                      | $          | 1,521,000            |       | $                          | 1,917,000  |   | $ | 68,000 |   |
| Payments to Law Firms       |       | 6,000,000 |       | 4,000,000                 |       | 2,000,000            |       | —                     |       |
| Total obligations           |       | $         | 9,506,000  |                      | $          | 5,521,000            |       | $                          | 3,917,000  |   | $ | 68,000 |   |

 

As of April 30, 2005, wedid not have any long-term debt obligations, purchase obligations, otherlong-term liabilities or material capital lease obligations.

Our ability to cut coststo offset revenue declines in our UNIX business is limited because ofcontractual commitments to maintain and support our existing UNIXcustomers.  This decline in our UNIX business may beaccelerated if industry partners withdraw their support as a result of ourSCOsource initiatives.  Our SCOsourceinitiatives 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.  Ifour UNIX products and services revenue is less than expected, our liquiditywill be adversely impacted.

                We have issued shares andgranted options under our Equity Compensation 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 Equity Compensation Plans or recover damages ifthey no longer own the shares or hold unexercised options, subject toapplicable statutes of limitations, and we may make a rescission offer tocertain of such plan participants subject to obtaining required regulatoryapprovals.  Additionally, regulatoryauthorities may require us to 

 

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pay fines or they may impose other sanctions onus, and we may face other claims by participants other than rescission claims.

                Ifour potential rescission offer is made and accepted by plan participantsholding shares acquired under the Equity Compensation 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 required to make aggregate payments to these plan participants of up to$851,000 in the aggregate, excluding interest and other possible fees, basedupon shares outstanding under the Equity Compensation Plans as of April 30,2005.

We may also faceadditional rescission liability to plan participants holding unexercised stockoptions in California, Georgia and possibly other states.  Regulatory authorities may require us to payfines or impose other sanctions on us. Although we believe that it is reasonably possible that some planparticipants holding unexercised options may accept a rescission offer orpotentially attempt to enforce a rescission right, we are unable to estimatethe number of participants who might pursue rescission or the potentialrescission liability we may have to them. Since any loss is considered reasonably possible but not estimable, wehave not recorded a liability for this contingency.

We may also be requiredto pay interest and penalties up to statutory limits in connection with plan participantsmaking rescission claims or in connection with any rescission offer.  We believe that it is reasonably possiblethat we may be required to pay interest and penalties, but are not able toestimate an amount.

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

*Foreign Currency Risk. *Wehave foreign offices and operations in Europe and Asia.  As a result, a portion of our revenue isderived from sales to customers outside the United States.  Our international revenue is denominated inU.S. dollars, Euros and United Kingdom Pounds. Most of the operating expenses related to our foreign-based operationsare denominated in foreign currencies and therefore operating results areaffected by changes in the U.S. dollar exchange rate in relation to foreigncurrencies such as the Euro, among others. If the U.S. dollar further weakens compared to the Euro, our operatingexpenses for foreign operations will be higher when translated back into U.S.dollars.  Our revenue can also beaffected by general economic conditions in the United States, Europe and otherinternational markets.  Our results ofoperations may be affected in the short term by fluctuations in foreigncurrency exchange rates.

We have in the pastutilized foreign currency forward exchange contracts for market exposures ofunderlying assets and liabilities.  We donot use forward exchange 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 such contract’s 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 April 30, 2005, we had no outstandinginstruments classified as hedges.

*Interest Rate Risk. *The primary objective ofour cash management strategy is to invest available funds in a manner thatassures maximum safety and liquidity and maximizes yield within suchconstraints.  We believe that ahypothetical movement in interest rates, either up or 

 

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down, would not have a material adverse impacton our cash and equivalents and available-for-sale securities.  We do not borrow money for short-terminvestment purposes.

*Investment Risk. *Wehave invested in equity instruments of privately held and public companies inthe technology industry for business and strategic purposes.  Investments are accounted for under the costmethod if our ownership is less than 20 percent, and we are not able toexercise influence over operations.  Ourinvestment policy is to regularly review the assumptions and operatingperformance of these companies and to record impairment losses when events andcircumstances indicate that these investments may be impaired.  As of April 30, 2005, our investments balancewas approximately $630,000 and was related to our investment in a 30 percentowned Chinese company.

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

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

*Evaluation of disclosure controlsand procedures.*  Under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, we evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rule13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that, as of the end ofthe period covered by this report, our disclosure controls and procedures wereeffective.

*Changes in internal control overfinancial reporting. *Duringthe most recent quarter ended April 30, 2005, we have implemented certain changesin our internal control over financial reporting (as defined in Rule 13a-15(f)under the Exchange Act).  We haveimplemented additional internal control procedures surrounding equity andequity issuances.  These internal controlprocedures consist of additional detail transactional controls including thetimely reconciliation and review of shares issued with shares available underregistration statements, an equity compliance checklist and additional reviewand approval procedures by persons with appropriate experience.  These additional controls were put in placeas the result of an identified material weakness in our accounting for capitalstock and stock option transactions as reported in our quarterly report on Form10-Q for the fiscal quarter ended January 31, 2005 and prior periodic reports.

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

#### ***With the exception of historicalfacts, the statements contained in Management’s Discussion and Analysis ofFinancial Condition and Results of Operations are “forward-looking statements”within the meaning of the Private Securities Litigation Reform Act of 1995,which reflect our current expectations and beliefs regarding our future resultsof operations, performance and achievements. These statements are subject torisks and uncertainties and are based upon assumptions and beliefs that may ormay not materialize.  Theseforward-looking statements include, but are not limited to, statementsconcerning:***

•                              Our belief that our UNIX business willcontinue to generate positive cash flow throughout fiscal year 2005;

 

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•                              Our expectation that industry partners,developers, and hardware and software vendors, may elect not to continue tosupport or certify to our UNIX operating system products;

•                              Our intention to release SCO OpenServer 6in June 2005;

•                              Our belief that SCO OpenServer 6 willprovide increased system reliability, backward compatibility with existingapplications and software, increased application and hardware support,integration with widely used internet applications and increased systemperformance, and our belief that these enhancements will not have a directimpact on our short-term SCO OpenServer revenue and that they will help prolongOpenServer revenue in future quarters;

•                              Our intention to continue to pursue ourSCOsource initiatives in fiscal year 2005;

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

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

•                              Our belief that our allowance and baddebts for accounts receivable will remain consistent with our prior experience;

•                              Our belief that competition from Linuxwill continue in fiscal year 2005 and future periods;

•                              Our expectation that we will continue tobe unable to predict the amount and timing of SCOsource licensing revenue, andwhen generated, the revenue will be sporadic;

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

•                              Our expectation for the remainingquarters of fiscal year 2005 that the dollar amount of our cost of productsrevenue will be generally consistent to that generated in the second quarter offiscal year 2005 and that the cost of products revenue as a percentage ofproducts revenue for the remaining quarters of fiscal year 2005 will begenerally consistent to that incurred in the second quarter of fiscal year2005;

•                              Our expectation for the remainingquarters of fiscal year 2005 that the dollar amount of our cost of servicesrevenue will be generally consistent to that generated in the second quarter offiscal year 2005 and that the cost of services revenue as a percentage ofservices revenue for the remaining quarters of fiscal year 2005 will begenerally consistent to that incurred in the second quarter of fiscal year2005;

•                              Our expectation for the remainingquarters of fiscal year 2005 that the dollar amount of our sales and marketingexpense will be generally consistent to that incurred in the second quarter offiscal year 2005;

•                              Our expectation for the remainingquarters of fiscal year 2005 that the dollar amount of our research anddevelopment expense will be generally consistent to that incurred in the secondquarter of fiscal year 2005;

 

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•                              Our expectation for the remainingquarters of fiscal year 2005 that the dollar amount of our general andadministrative expense will be generally consistent to that generated in thefirst quarter of fiscal year 2005;

•                              Our belief that we will use cash ofapproximately $7,000,000 in the defense of our SCO Litigation during theremainder of the year ending October 31, 2005;

•                              Ourexpectation that our UNIX business will generate sufficient cash in the yearending October 31, 2005 to cover our internal costs related to our SCOsourceinitiatives and the SCO Litigation, and our belief that we will have sufficientcash resources to fund our operations through October 31, 2005; and

•                              Ourexpectation that the dollar amount of our cost of SCOsource licensing for theremaining quarters of fiscal year 2005 will be generally consistent with thecosts incurred in the first two quarters of fiscal year 2005.

Wewish to caution readers that our operating results are subject to various risksand uncertainties that could cause our actual results and outcomes to differmaterially from those discussed or anticipated, including the success of ourSCOsource initiatives, competition from other operating systems, particularlyLinux, the amount and timing of SCOsource licensing revenue, our ability toenhance our UNIX operating systems and maintain our UNIX business, and thefactors set forth in the 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***

*We do not have a history of profitable operations.*

Our fiscal year endedOctober 31, 2003 was the first full year we were profitable in our operatinghistory.  Our profitability in fiscalyear 2003 resulted primarily from our SCOsource licensing initiatives.  For fiscal year 2004, we incurred a net lossfrom operations of $28,573,000 and our accumulated deficit as of October 31,2004 was $224,216,000.  For the first twoquarters of fiscal year 2005 we incurred a net loss from operations of$6,065,000 and had an accumulated deficit of $229,139,000.

If our revenue from thesale of our UNIX products and services continues to decline, we will need tofurther reduce operating expenses to generate positive cash flow.  We may not be able to further reduceoperating expenses without damaging our ability to support our existing UNIXbusiness.  Additionally, we may not beable to achieve profitability through additional cost-cutting actions.

OurUNIX products and services revenue has declined over the last several yearsprimarily as a result of increased competition from alternative operatingsystems, particularly Linux.  In ourquarterly results of operations, we recognize revenue from agreements forsupport and maintenance contracts and other long-term contracts that have beenpreviously invoiced and are included in deferred revenue.  Our future UNIX revenue may be adverselyimpacted and may continue to decline if we are unable to replenish these deferredrevenue balances with long-term maintenance and support contracts or replacethem with other sustainable revenue streams. If we are unable to generate positive cash flow and profitableoperations, our operations will be adversely impacted.

 

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

 

We continue to pursueour SCO Litigation and believe in the merits of our cases.  In our action against IBM, we seek damages forclaims generally relating to our allegation that IBM has inappropriately usedand distributed our UNIX source code and derivative works in connection withits efforts to promote the Linux operating system.  IBM has responded to our claims and brought counterclaimsagainst us asserting generally that we do not have the right to assert claimsbased on our ownership of UNIX intellectual property against IBM or others inthe Linux market.  Discovery iscontinuing in the case, and several motions are currently pending before thecourt.  If we do not prevail in ouraction against IBM, or if IBM is successful in its counterclaims against us,our business and results of operations would be materially harmed and we maynot be able to continue in business.  Thelitigation with IBM and others will be costly, and our costs for legal feeshave been and will continue to be substantial and may exceed our capitalresources. Additionally, the market price of our common stock may be negativelyaffected as a result of developments in our legal action against IBM that maybe, or may be perceived to be, adverse to us.

As a result of our SCOLitigation and our other SCOsource initiatives, several participants in theLinux industry and others affiliated with IBM or sympathetic to the Linuxmovement have taken actions attempting to negatively affect our business andour SCOsource efforts.  Linux proponentshave taken a broad range of actions against us, including, for example,attempting to influence participants in the markets in which we sell ourproducts to reduce or eliminate the amount of our products and services theypurchase from us.  We expect that similarefforts likely will continue.  There is arisk that participants in our marketplace will negatively view our action againstIBM, Novell, DaimlerChrysler and AutoZone and our other SCOsource initiatives,and we may lose support from such participants. Any of the foregoing could adversely affect our position in themarketplace, our results of operations and our stock price and our ability tostay in business.

As a further response toour SCOsource initiatives and claim that our UNIX source code and derivativeworks have inappropriately been included in Linux, Novell has publicly assertedits belief that it owns certain copyrights in our UNIX source code, and it hasfiled 15 copyright applications with the United States Copyright Office relatedto UNIX.  Novell also claims that it hasa license to UNIX from us and the right to authorize its customers to use UNIXtechnology in their internal business operations.  Specifically, Novell has also claimed to haveretained rights related to legacy UNIX SVRx licenses, including the licensewith IBM.  Novell asserts it has theright to take action on behalf of SCO in connection with such licenses,including termination rights.  Novell haspurported to veto our termination of the IBM, Sequent and SGI licenses. We haveasserted that we obtained the UNIX business, source code, claims and copyrightswhen we acquired the assets and operations of the server and professionalservices groups from The Santa Cruz Operation (now Tarantella, Inc.) inMay 2001, which had previously acquired all such assets and rights fromNovell in September 1995 pursuant to an asset purchase agreement, asamended.  In January 2004, in response toNovell’s actions, we brought suit against Novell for slander of title seekingrelief for Novell’s alleged bad faith effort to interfere with our copyrightsand contract rights related to our UNIX source code and derivative works andour UnixWare products.  Novell is seekingdismissal of this case.

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 causefurther damage to our business including our ability to monetize our UNIXassets.  These efforts of Linuxproponents also may increase the negative view some participants in ourmarketplace have regarding our SCO Litigation and regarding our SCOsourceinitiatives and may contribute to creating confusion in the marketplace aboutthe validity of our claim that the unauthorized use of our UNIX source code andderivative 

 

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works in Linux infringes on our copyrights.  Increased negative perception and potentialconfusion about our claims in our marketplace could impede our continuedpursuit of our SCOsource initiatives and negatively impact our business.

*Our EngagementAgreement with the Law Firms will require us to spend a significant amount ofcash during fiscal year 2005 and could harm our liquidity position.*

As of April 30, 2005, wehad a total of $14,192,000 in cash and cash equivalents and available-for-salesecurities and an additional $3,967,000 as restricted cash to be used in ouroperations and pursue the SCO Litigation. As a result of the Engagement Agreement between us and the Law Firms,for the remainder of fiscal year 2005 we anticipate spending approximately$7,000,000 in the defense of our SCO Litigation during fiscal year 2005, whichwould leave us approximately $11,159,000 in cash for our business operations asof October 31, 2005.  We expect that ourUNIX business will generate sufficient cash in fiscal year 2005 to cover ourinternal costs related to our SCOsource initiatives and SCO Litigation.  However, if our UNIX business does notgenerate cash or we spend additional cash on the SCO Litigation or additionalmatters, our cash position would be negatively impacted, and our ability topursue our UNIX business objectives and our SCO Litigation could be harmed.

*Our future SCOsource licensing revenue is uncertain.*

We initiated theSCOsource licensing effort in fiscal year 2003 to review the status of UNIXlicensing and sublicensing agreements. This effort resulted in the execution of two significant vendor licenseagreements during fiscal year 2003 and generated $25,846,000 in revenue.  During fiscal year 2004, our SCOsourcelicensing revenue declined significantly and was only $829,000.  Due to a lack of historical experience andthe uncertainties related to SCOsource licensing revenue, we are unable toestimate the amount and timing of future SCOsource licensing revenue, ifany.  If we do receive revenue from thissource, it may be sporadic and fluctuate from quarter to quarter.  Our SCOsource initiatives are unlikely toproduce stable, predictable revenue 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 derivatives are prevalent in Linux.

*We may losethe support of industry partners leading to an accelerated decline in our UNIXproducts and services revenue.*

                The decline in our UNIX business and our SCOsourceinitiatives 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 would adverselyimpact our results of operations and liquidity.

*Our claimsrelating to our UNIX intellectual property may subject us to additional legalproceedings.*

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

 

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                In addition, regulators or others in the Linux marketand some foreign regulators have initiated or in the future may initiate legalactions against us, all of which may negatively impact our operations andfuture 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.*

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

                Factors that may affect our results include:

                                                •              our ability to successfully negotiate and completelicensing and other agreements related to our intellectual property;

                                                •              the interest level of resellers in recommending ourUNIX business solutions to end users;

                                                •              the introduction, development, timing, competitivepricing and market acceptance of our products and services and those of ourcompetitors;

                                                •              changes in general economic conditions, such asrecessions, that could affect capital expenditures in the software industry;

                                                •              results of, or developments in our SCO Litigation;

                                                •              changes in business attitudes toward UNIX as a viableoperating system compared to other competing systems, especially Linux;

                                                •              the contingency and other legal fees we may pay to theLaw Firms representing us in our efforts to establish our intellectual propertyrights; and

                                                •              changes in attitudes of customers and partners due tothe decline in our UNIX business and our aggressive position against theinclusion of our UNIX code and derivative works in Linux.

                We also experience fluctuations in operating resultsin interim periods in Europe and the Asia Pacific regions due to seasonalslowdowns and economic conditions in these areas.  Seasonal slowdowns in these regions typicallyoccur during the summer months.

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

*We operate ina highly competitive market and face significant competition from a variety ofcurrent and potential sources; many of our current and potential competitorshave greater financial and technical resources than we do; thus, we may fail tocompete effectively.*

                Inthe operating system market, our competitors include IBM, Red Hat, Novell,Hewlett-Packard, Sun, Microsoft and other Linux distributors.  These and other competitors are aggressivelypursuing the current UNIX operating system market.  Many of these competitors have 

 

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access to substantially greaterresources than we do.  The majorcompetitive alternative to our UNIX products is Linux.  The expansion of our competitors’ offeringsmay restrict the overall market available for our UNIX products, including somemarkets where we have been successful in the past.

                Our future success may depend in part on our abilityto continue to meet the increasing needs of our customers by supportingexisting and emerging technologies.  Ifwe do not enhance our products to meet these evolving needs, we may not remaincompetitive and be able to grow our business. Additionally, because technological advancement in the UNIX operatingsystem market and alternative operating system markets is progressing at anadvanced pace, we will have to develop and introduce enhancements to ourexisting products and any new products on a timely basis to keep pace withthese developments, evolving industry standards and changing customerrequirements.  Our failure to meet any ofthese and other competitive pressures may render our existing products andservices obsolete, which would have an adverse impact on our revenue andoperations.

                The success of our UNIX business will depend on thelevel of commitment and certification we receive from industry partners anddevelopers.  In recent years, we haveseen hardware and software vendors as well as software developers turn theircertification and application development efforts toward Linux and elect not tocontinue to support or certify to our UNIX operating system products.  If this trend continues, our competitiveposition will be adversely impacted and our future revenue from our UNIXbusiness will decline.  The decline inour UNIX business may be accelerated if industry partners withdraw theirsupport from us for any reason, including our SCOsource initiatives.

*If the marketfor UNIX continues to contract, our business will be harmed.*

                Our revenue from the sale of UNIX products hasdeclined over the last several years. This decrease in revenue has been attributable primarily to increasedcompetition from other operating systems, particularly Linux.  Our sales of UNIX products and services areprimarily to existing customers.  If thedemand for UNIX products continues to decline, and we are unable to developUNIX products and services that successfully address a market demand, our UNIXrevenue will continue to decline, industry participants may not certify to ouroperating system and products, we may not be able to attract new customers orretain existing customers and our business and results of operations will beadversely affected.  Because of the longadoption cycle for operating system purchases and the long sales cycle of ouroperating system products, we may not be able to reverse these revenue declinesquickly.

*We rely onour indirect sales channel for distribution of our products, and any disruptionof our channel at any level could adversely affect the sales of our products.*

                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 solutionproviders also purchase solutions through our resellers, and we anticipate theywill continue to do so.  Because weusually 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 be affected by disruptions in therelationships between us and our resellers, between our resellers and solutionproviders, or between solution providers and end users.  Also, resellers and solution providers maychoose not to emphasize our products to their customers.  Any of these occurrences could diminish theeffectiveness of our distribution channel and lead to decreased sales.

 

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

                Our Engagement Agreement with the Law Firms couldinhibit our ability to raise additional funding if needed.  Although under the Engagement Agreement ourobligations to the Law Firms are limited to approximately $26,000,000 relatedto certain previously accrued and all future attorney fees and the escrow of $5,000,000for the payment of any expert, consulting and other expenses to pursue the SCOLitigation, the agreement provides that the Law Firms will receive acontingency fee that may range from 20 to 33 percent of the proceeds fromspecified events related to the protection of our intellectual propertyrights.  Events triggering a contingencyfee may include settlements or judgments related to the SCO Litigation, certainlicensing fees, subject to certain exceptions, and a sale of our company.  Future payments payable to the Law Firmsunder this arrangement will be significant. The Law Firms’ right to receive such contingent payments could causeprospective investors to choose not to invest in our company or limit the priceat which new investors would be willing to provide additional funds to ourcompany.

*Our foreign-basedoperations and sales create special problems, including the imposition ofgovernmental controls and taxes and fluctuations in currency exchange ratesthat could hurt our results.*

                We have foreign operations, including developmentfacilities, sales personnel and customer support operations in Europe, LatinAmerica and Asia.  These foreignoperations are subject to certain inherent risks, including:

                                                •              potential loss of developed technology through piracy,misappropriation, or more lenient laws regarding intellectual propertyprotection;

                                                •              imposition of governmental controls, including traderestrictions and other tax requirements;

                                                •              fluctuations in currency exchange rates and economicinstability;

                                                •              longer payment cycles for sales in foreign countries;and

                                                •              seasonal reductions in business activity.

                In addition, certain of our operating expenses aredenominated in local currencies, creating risk of foreign currency translationlosses that could harm our financial results and cash flows. When we generateprofits in foreign countries, our effective income tax rate is increased.

                In Latin America and Asia in particular, severalcountries have suffered and may be especially susceptible to recessions andeconomic instability, which may lead to increased governmental ownership orregulation of the economy, higher interest rates, increased barriers to entrysuch as higher tariffs and taxes, and reduced demand for goods manufactured inthe United States, resulting in lower revenue.

                Duringthe second quarter of fiscal year 2004, our Indian office was given awithholding 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 fortreatment as royalties 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.

 

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

                We need to retain our management, technical, andsupport personnel.  Competition forqualified professionals in the software industry is intense, and departures ofexisting personnel could be disruptive to our business and might result in thedeparture of other employees.  The lossor departure of any officers or key employees could harm our ability toimplement our business plan and could adversely affect our operations.  Our future success depends to a significantextent on the continued service and coordination of our management team,particularly Darl C. McBride, our President and Chief Executive Officer.

*We have issued shares and optionsunder our Equity Compensation Plans without complying with registration orqualification requirements under federal and state securities laws, and, as aresult, we may incur rescission liability for such shares and options and mayface additional potential claims under federal and state securities laws.*

We have issued shares andoptions granted under our Equity Compensation Plans without complying withregistration or qualification requirements under federal securities laws andthe securities laws of certain states. As a result, certain plan participants that have acquired shares issuedunder the Equity Compensation Plans have rescission rights against us, subjectto applicable statutes of limitations, and we 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.

                Ifour possible rescission offer is made and accepted by plan participants holdingshares acquired under the Equity Compensation Plans or otherwise entitled torecover damages from us in respect of such shares they have sold we could beliable to make aggregate payments to these plan participants of up to $851,000in the aggregate, excluding interest and other possible fees, based upon sharesoutstanding under the Equity Compensation Plans as of April 30, 2005.

                Wemay face additional rescission liability to plan participants holdingunexercised stock options in California and possibly other states.  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 plan participant’s right to rescind a sale of stockthat was not registered as required under federal law.  If we do not make the planned rescissionoffer to all plan participants, or any or all of the offerees reject therescission offer, we may continue to be liable under federal and statesecurities laws.

*Our stock price is volatile.*

*               *The trading price for our common stock has been volatile,ranging from a low closing sales price of $1.09 in mid-February 2003, to ahigh closing sales price of $20.50 per share in October 2003, to a currentsales price of $4.12 on May 27, 2005.  Theshare price has changed dramatically over short periods.  We believe that the changes in our stockprice are affected by changing public perceptions concerning the strength ofour intellectual property claims and other factors beyond our control.  Public perception can change quickly andwithout any change or development in our underlying business or litigationposition.  An investment in our stock issubject to such volatility and, consequently, is subject to significant risk.

*There are risksassociated with the potential exercise of our outstanding options.*

                Asof May 27, 2005, we have issued and outstanding options to purchase up toapproximately 3,430,000 shares of common stock with an average exercise priceof $4.18 per share.  The existence ofsuch rights to acquire common stock at fixed prices may prove a hindrance toour 

 

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efforts to raise future equityand debt funding, and the exercise of such rights will dilute the percentage ownershipinterest of our stockholders and may dilute the value of their 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.

*The issuanceof common shares to BayStar may have an adverse impact on the market value ofour stock and the existing holders of our common stock.*

                We previously had an effective registration statementon Form S-3 relating to the sale or distribution by BayStar as a sellingstockholder of the 2,105,263 shares of common stock issued to BayStar in connectionwith our repurchase completed in July 2004 of all Series A-1 shares previouslyheld by BayStar.  When we failed to fileour annual report on Form 10-K for the fiscal year ended October 31, 2004 in atimely fashion, we became ineligible to use Form S-3, our registrationstatement ceased to be effective and BayStar’s ability to resell sharespursuant to that registration statement terminated.  We are currently in the process of preparinga new registration statement for the resale of BayStar’s shares on FormS-1.  Upon that registration statementbeing declared effective by the SEC, BayStar will again be able to resell itsshares.  We will not receive any proceedsfrom the sales of the shares covered by such registration statement.  The shares that may be sold or distributedpursuant to such registration statement, upon being declared effective by theSEC, will represent approximately 6 percent of our issued and outstandingcommon stock.  The sale of the block ofstock to be covered by such registration statement, or even the possibility ofits sale, may adversely affect the trading market for our common stock andreduce the price available in that market.

*Our stockprice could decline further because of the activities of short sellers.*

                Our stock has attracted theinterest of short sellers.  Theactivities of short sellers could further reduce the price of our stock orinhibit increases in our stock price.

*The right ofour board of directors to authorize additional shares of preferred stock couldadversely impact the rights of holders of our common stock.*

                Our board of directors currently has the right, withrespect to the 5,000,000 shares of our preferred stock, to authorize theissuance of one or more additional series of our preferred stock with such voting,dividend and other rights as our directors determine.  The board of directors can designate newseries of preferred stock without the approval of the holders of our commonstock. The rights of holders of our common stock may be adversely affected bythe rights of any holders of additional shares of preferred stock that may beissued in the future, including without limitation, further dilution of theequity ownership percentage of our holders of common stock and their votingpower if we issue preferred stock with voting rights. Additionally, theissuance of preferred stock could make it more difficult for a third party toacquire a majority of our outstanding voting stock.

*Our Stockholder Rights Plan couldmake it more difficult for a hostile bid for the Company or a change of controltransaction to succeed at current market prices for our stock.*

                Wehave adopted a Stockholder Rights Plan (“Rights Plan”).  The power given to the Board of Directors bythe Rights Plan may make it more difficult for a change of control of ourcompany to occur or for the Company to be acquired when the acquisition isopposed by our Board of Directors.

**PARTII.                OTHER INFORMATION**

**ITEM 1.            LEGAL PROCEEDINGS**

 

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Thefollowing includes updated information relating to certain of our materiallegal proceedings as previously reported in our annual report on Form 10-K forfiscal year 2004 and our quarterly report on Form 10-Q for the quarter endedJanuary 31, 2005.

*IBM Corporation*

On or about March 6, 2003,we filed a complaint against IBM Corporation (“IBM”).  This action is pending in the United StatesDistrict Court for the District of Utah, under the title The SCO Group, Inc. v.International Business Machines Corporation, Civil No. 2:03CV0294.  This action includes, among other things, weclaim against IBM for breach of contract, copyright infringement, tortiousinterference, and unfair competition relating to IBM’s alleged use anddistribution of information concerning the UNIX source code and derivativeworks in connection with its efforts to promote the Linux operatingsystem.  IBM has responded to our claimsand made counterclaims against us.

Following ahearing on October 19, 2004, on January 19, 2005, the United States MagistrateJudge overseeing the case issued an order granting in part and denying in partdiscovery applications that we had made. The Court ordered IBM to produce much of the information, includingsource code, revision information, and programmer contribution information,that we had previously requested.  Thecourt also struck the Amended Scheduling Order and directed the parties tosubmit a proposed amended scheduling order to the court, which both partieshave done.  The District Court heardargument on the proposed schedules on April 21, 2005 and took the matter underadvisement.  It is anticipated that theCourt will issue a new scheduling order in the near future.

In response tothe Magistrate Court’s Order, IBM filed, on February 11, 2005, a Motion forReconsideration of the portion of the Order that required IBM to produceprogrammer-contribution information for 3,000 people.  IBM also filed, on March 9, 2005,  a Motion for a 45-day Extension of Time toComply with the Court’s January 18 Order as it applies to materials that arenot the subject of IBM’s above-referenced Motion for Reconsideration.  On March 16, 2005, the Court granted theextension and entered an order requiring IBM to produce those materials by May3, 2005.  With respect to the materialscovered by IBM’s Motion for Reconsideration, the Court granted IBM’s request tostay its discovery obligations pending the Court’s resolution of its motion.

On April 19,2005, the Magistrate Court ruled on IBM’s reconsideration motion.  The Court declined to strike its priorrequirement that IBM produce documents from the files of the 3,000 individualswho made the most contributions and changes to the development of AIX andDynix.  The Court reiterated itsrequirement that IBM produce programmer’s notes, design documents, whitepapers, comments and notes, contact information, specific changes made to code,and all relevant non-privileged documents from the files of the 100 individualswho made the most contributions and changes to the development of AIX and Dynix;ordered IBM to provide a privilege log for any documents withheld from thefiles of those 100 individuals; and required IBM to comply within 90 days.  The Court deferred the remainder of IBM’srequired production pending our review of the above-described discovery.  The Court also reiterated that IBM isrequired to produce all non-public Linux contribution information and directedIBM to produce all such information within 75 days.

                OnFebruary 9, 2005, the United States District Judge ruled on several pendingdispositive motions.  The Court deniedthe three motions for partial summary judgment that IBM had filed on ourcontract claims, on IBM’s eighth counterclaim for copyright infringement, andon IBM’s tenth counterclaim for a declaration of non-infringement of ourcopyrights.  The Court denied each ofthose motions without prejudice to IBM’s renewing or refiling the motions afterdiscovery is complete.  The Court alsodenied our motion to stay or dismiss IBM’s tenth 

 

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counterclaim.  The Court ordered that no further dispositivemotions could be filed until the close of discovery, except by stipulation ofthe parties, and vacated its prior order, dated September 30, 2004, to the extentthat order had granted permission to file dispositive motions before the closeof discovery.

Additionaldiscovery motions that we have filed are also pending before the Court.  On January 12, 2005, we filed its Motion toCompel IBM to produce IBM CEO Samuel J. Palmisano for Deposition.  The parties have fully briefed this motion,and the Court heard argument on that motion on April 21, 2005.  The Court took the matter under advisement.  The parties have also now fully briefed ourDecember 23, 2004 Renewed Motion to Compel Discovery, which seeks to compel IBM’scompliance with prior Court orders relating to IBM’s obligation to produce (1)all documents pertaining to Linux from the files of high-level IBM executivesand board members; and (2) to compel IBM to produce witnesses to testify onseveral topics in two deposition notices that SCO has served on IBM.  The Court has not set a hearing date for thismotion.

In addition tothe materials that have been publicly filed with the Court, certain informationhas been filed under seal in accordance with the protective order entered inthe case.  On November 30, 2004, a thirdparty moved to intervene in the case for the purpose of challenging the sealingof certain documents filed with the Court, and additional groups subsequentlyjoined in that motion.  Followingargument on April 26, 2005, by Order dated April 28, 2005, the Court denied theintervention motion.  In its Order, theCourt set forth various procedures to minimize the risk that documents would beimproperly filed under seal.

We have alsofiled a motion for leave to file a third amended complaint in order to assertan additional copyright claim against IBM in the case.  The Court heard argument on that fullybriefed motion on April 21, 2005 and took the matter under advisement.

In support ofits pending motion to amend, we argued that IBM would not be prejudiced by theproposed amendment because, among other things, our new claim pertained toissues already covered by IBM’s own Ninth Counterclaim, which seeks a broaddeclaratory judgment of non-infringement relating to AIX.  On February 18, 2005, IBM filed a Motion forEntry of Order Limiting the Scope of Its Ninth Counterclaim.  That motion has also been briefed, but noargument date has been set.

Discovery is continuing in the case. We are reviewing that discovery and currently anticipate that we willseek to amend our complaint in the near future in order to assert additionalclaims against IBM.

*AutoZone, Inc.*

Onor about March 2, 2004, we brought suit against AutoZone, Inc. (“AutoZone”) forits alleged violations of our UNIX copyrights through its use of Linux.  The lawsuit alleges copyright infringement byAutoZone by, among other things, running versions of the Linux operating systemthat contain proprietary material from UNIX System V.  The lawsuit, filed in United States DistrictCourt in Nevada, requests injunctive relief against AutoZone’s further use orcopying of any part of our copyrighted materials and also requests damages as aresult of AutoZone’s infringement in an amount to be proven at trial.  In response to AutoZone’s motion to transferthe case to Tennessee or stay the case, the federal court in Nevada grantedAutoZone’s motion to stay the case, with 90-day status reports to the court,and denied without prejudice AutoZone’s motion to transfer the case toTennessee.  The federal court allowed theparties to take limited expedited discovery relating to the issue ofpreliminary injunctive relief which discovery was concluded in May 2005.

Wehave concluded the initial discovery allowed by the court and filed our reportwith the court on May 27, 2005.  Contraryto AutoZone’s own statements to the court, we found 

 

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through discovery, including depositions and otheradmissions of AutoZone, many instances of copying of programs containing SCOOpenServer code.  AutoZone hasrepresented that it has now removed all of the SCO code and proprietaryinformation it copied or used in its migration to Red Hat Linux.  Because AutoZone represents it has removed orotherwise is not using SCO code and proprietary information, we currently donot intend to move for a preliminary injunction.  AutoZone does not admit that it violated ourrights or caused us damage in that migration process, which are still points ofdispute between the parties.  Given thestay issued by the Court in the case, we reserve the right to pursueinfringement and damages in the future based on these issues and other issuesstayed by the Court.

**ITEM 2.            CHANGES IN SECURITIES AND USE OFPROCEEDS**

**Recent Sales of Unregistered Securities**

                Asdescribed elsewhere in this Form 10-Q, we have issued shares and grantedoptions under our Equity Compensation Plans without complying with registrationor qualification 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 Equity Compensation Plans or recover damages if they no longer ownthe shares or hold unexercised options, subject to applicable statutes oflimitations.  Additionally, regulatoryauthorities may require us to pay fines or impose other sanctions on us.  Although we are evaluating the possibleactions we may take in response to these securities law compliance issues, wemay, subject to obtaining required regulatory approvals, make a rescissionoffer to certain plan participants that hold unexercised options (inCalifornia, Georgia and possibly other states) or shares acquired under theEquity Compensation Plans or that otherwise are entitled to recover damagesfrom us in respect of such shares they have sold.

**ITEM 5.            OTHER INFORMATION**

One December 8, 2004, our board of directors adoptedThe SCO Group Employee Incentive Bonus Program for fiscal year 2005, whichsubsequently was ratified and approved by the compensation committee of ourboard of directors (the “Bonus Program”). Pursuant to the Bonus Program, all employees, including the executiveofficers identified in the table below, other than certain sales employees, mayearn quarterly cash bonuses.

A bonus under the Bonus Program may only be paid forany quarter of fiscal year 2005 if our company meets specific revenue andoperating performance objectives for such quarter.  If these two performance objectives aresatisfied, bonuses will be paid and additional bonuses may be earned ifexecutive officers satisfy certain specified personal objectives.  These personal objectives are established bythe Compensation Committee for Mr. McBride, our President and Chief ExecutiveOfficer, and by Mr. McBride for the other executive officers.

The bonus payments made to our executive officers forthe quarter ended January 31, 2005 were as follows:  

 

| **Name**                                                  | ** ** | **Bonus**

**for Q1 2005** | ** ** |
|-----------------------------------------------------------|------------|----------------------------|------------|
| Darl C. McBride  President and Chief Executive Officer    |       | $                          | 47,071     |   |
| Bert B. Young  Chief Financial Officer                    |       | $                          | 17,255     |   |
| Chris Sontag  Senior Vice President, Business Development |       | $                          | 16,240     |   |

 

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| Jeff Hunsaker  Senior Vice President and General Manager, UNIX Division |       | $     | 16,240      |       |
|-------------------------------------------------------------------------|------------|-------|-------------|------------|
| Ryan E. Tibbitts  General Counsel and Corporate Secretary               |       | $     | 14,718      |       |
| **TOTALS**                                                              | ** ** | **$** | **111,524** | ** ** |

                This description of theBonus Program is subject to, and qualified in its entirety by, the The SCOGroup Employee Incentive Bonus Program****forfiscal year 2005 attached to the January 31, 2005 Form 10-Q as Exhibit 10.1.

**ITEM 6.            EXHIBITS**

(a)                                  Exhibits

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

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

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

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

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

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

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

31.2                           Certificationof Bert B. Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of theExchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of2002.

32.1                           Certificationof Darl C. McBride, President and Chief Executive Officer, pursuant to Section1350, Chapter 63 of Title 18, United States Code, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002.

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

**ITEM 7.            SIGNATURES**

 

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Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
| Date: June 2, 2005 | THE SCO GROUP, INC. |
|--------------------|---------------------|
|               |                |
|               |                | By: | /s/     Bert Young |   |
|               |                |   | Bert Young |
|               |                |   | Duly Authorized Officer  and |
|               |                |   | Chief Financial Officer |
|               |                |   | (Principal Financial and |
|               |                |   | Accounting Officer) |

 

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**EXHIBITINDEX**

** **

** **
| **Exhibit Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                                        |
|--------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **         | ** ** | ** **                                                                                                                                                                                                                                                     |
| 3.1                |       | Amended and Restated  Certificate of Incorporation of Caldera International, Inc. (incorporated by  reference to Exhibit 3.1 to SCO’s Registration Statement on Form 8-A12G/A  (File No. 000-29911)).

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

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

  |
| 3.4                |       | Amended and Restated  Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s Registration  Statement on Form 8-A12G/A (File No. 000-29911)).

                                                                                                    |
| 3.5                |       | Certificate of Designation  for Series A-1 Convertible Preferred Stock (incorporated by reference to  Exhibit 4.1 to SCO’s Current Report on Form 8-K filed on February 9, 2004  (File No. 000-29911)).

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

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

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

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

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

** **

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