**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark one)**

 

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

 

**For the quarterly period ended July 31, 2004**

 

**OR**

 

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

 

**For the transition period from               to**

 

**Commission file****number 0-29911**

 

**THE SCO GROUP, INC.**

(Exact name of registrant as specified inits charter)

 
| **Delaware**                                                    | ** ** | **87-0662823**                          |
|-----------------------------------------------------------------|------------|-----------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification Number) |
|                                                            |       |                                    |
| **355 South 520 West  Suite 100  Lindon, Utah 84042**           |
| (Address of principal executive offices  and zip code)          |
|                                                            |       |                                    |
| **(801) 765-4999**                                              |
| (Registrant’s telephone number, including  area code)      |

 

Indicate bycheck mark whether the Registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to filing requirementsfor the past 90 days.

 

YES ýNO o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act)

 

YES ýNO o

 

*As of September 13, 2004, there were17,484,473 shares of the Registrant’s common stock, $0.001 par value per share,outstanding.*

 

 

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**The SCOGroup, Inc.**

 

**Table of Contents**

 
| PART I.   | FINANCIAL INFORMATION                                                                                                                        |   |
|-----------|----------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.   | Financial Statements                                                                                                                         |   |
|      | Condensed  Consolidated Balance Sheets as of July 31, 2004 and October 31, 2003                                                              |   |
|      | Condensed Consolidated Statements of  Operations and Comprehensive Income (Loss) for the three and nine months  ended July 31, 2004 and 2003 |   |
|      | Condensed Consolidated Statements of Cash  Flows for the nine months ended July 31, 2004 and 2003                                            |   |
|      | Notes to Condensed Consolidated Financial  Statements                                                                                        |   |
| Item  2.  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                  |   |
| Item 3.   | Quantitative and Qualitative Disclosures About  Market Risk                                                                                  |   |
| Item 4.   | Controls and Procedures                                                                                                                      |   |
|      | Forward-Looking Statements                                                                                                                   |   |
|      | Risk  Factors                                                                                                                                |   |
| PART  II. | OTHER  INFORMATION                                                                                                                           |   |
| Item 1.   | Legal  Proceedings                                                                                                                           |   |
| Item 2.   | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                 |   |
| Item 6.   | Exhibits                                                                                                                                     |   |
| Item 7.   | Signatures                                                                                                                                   |   |

 

2

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**THESCO GROUP, INC. AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(unaudited, in thousands)**

 
| ** **                                                                                                              | ** ** | **July 31,  2004** | ** ** | **October 31,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
|                                                                                                                    |       |               |       |                  |       |
| **ASSETS**                                                                                                              | ** ** | ** **         | ** ** | ** **            | ** ** |
|                                                                                                                    |       |               |       |                  |       |
| CURRENT ASSETS:                                                                                                         |       |               |       |                  |       |
| Cash and cash equivalents                                                                                               |       | $                  | 15,982     |                  | $          | 64,428 |   |
| Restricted cash                                                                                                         |       | 13,506             |       | 2,025                 |       |
| Available-for-sale securities                                                                                           |       | 27,045             |       | 4,095                 |       |
| Accounts receivable, net of allowance for  doubtful accounts of $126 and $230, respectively                             |       | 5,954              |       | 9,282                 |       |
| Other current assets                                                                                                    |       | 2,466              |       | 2,450                 |       |
| Total current assets                                                                                                    |       | 64,953             |       | 82,280                |       |
|                                                                                                                    |       |               |       |                  |       |
| PROPERTY AND EQUIPMENT:                                                                                                 |       |               |       |                  |       |
| Computer and office equipment                                                                                           |       | 3,608              |       | 3,482                 |       |
| Leasehold improvements                                                                                                  |       | 565                |       | 608                   |       |
| Furniture and fixtures                                                                                                  |       | 186                |       | 189                   |       |
|                                                                                                                    |       | 4,359              |       | 4,279                 |       |
| Less accumulated depreciation and  amortization                                                                         |       | (3,560             | )          | (3,131                | )          |
| Net property and equipment                                                                                              |       | 799                |       | 1,148                 |       |
|                                                                                                                    |       |               |       |                  |       |
| OTHER ASSETS:                                                                                                           |       |               |       |                  |       |
| Goodwill                                                                                                                |       | —             |       | 1,166                 |       |
| Intangibles, net                                                                                                        |       | 6,090              |       | 9,286                 |       |
| Other assets, net                                                                                                       |       | 1,390              |       | 1,072                 |       |
| Total other assets                                                                                                      |       | 7,480              |       | 11,524                |       |
|                                                                                                                    |       |               |       |                  |       |
| Total assets                                                                                                            |       | $                  | 73,232     |                  | $          | 94,952 |   |
|                                                                                                                    |       |               |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                           | ** ** | ** **         | ** ** | ** **            | ** ** |
|                                                                                                                    |       |               |       |                  |       |
| CURRENT LIABILITIES:                                                                                                    |       |               |       |                  |       |
| Accounts payable                                                                                                        |       | $                  | 1,825      |                  | $          | 1,978 |   |
| Payable to BayStar II, LLP                                                                                              |       | 13,000             |       | —                |       |
| Royalty payable to Novell, Inc.                                                                                         |       | 506                |       | 2,025                 |       |
| Accrued compensation to law firms                                                                                       |       | 7,956              |       | 10,556                |       |
| Accrued payroll and benefits                                                                                            |       | 3,075              |       | 4,752                 |       |
| Accrued liabilities                                                                                                     |       | 10,749             |       | 3,754                 |       |
| Derivative related to redeemable  convertible preferred stock                                                           |       | —             |       | 15,224                |       |
| Deferred revenue                                                                                                        |       | 5,936              |       | 5,501                 |       |
| Other royalties payable                                                                                                 |       | 171                |       | 523                   |       |
| Taxes payable                                                                                                           |       | 1,361              |       | 799                   |       |
| Total current liabilities                                                                                               |       | 44,579             |       | 45,112                |       |
|                                                                                                                    |       |               |       |                  |       |
| LONG-TERM LIABILITIES                                                                                                   |       | 501                |       | 508                   |       |
|                                                                                                                    |       |               |       |                  |       |
| MINORITY INTEREST                                                                                                       |       | —             |       | 145                   |       |
|                                                                                                                    |       |               |       |                  |       |
| SERIES A REDEEMABLE CONVERTIBLE PREFERRED  STOCK,  $0.001 par value, 0 and 50 shares outstanding, respectively (Note 5) |       | —             |       | 29,671                |       |
|                                                                                                                    |       |               |       |                  |       |
| COMMITMENTS AND CONTINGENCIES (Note 6)                                                                                  |       |               |       |                  |       |
|                                                                                                                    |       |               |       |                  |       |
| STOCKHOLDERS’ EQUITY:                                                                                              |       |               |       |                  |       |
| Preferred stock, $0.001 par value; 5,000  shares authorized,                                                            |       | —             |       | —                |       |
| Common stock, $0.001 par value; 45,000  shares authorized, 17,750 and 13,824 shares outstanding, respectively           |       | 18                 |       | 14                    |       |
| Additional paid-in capital                                                                                              |       | 246,440            |       | 218,690               |       |
| Common stock held in treasury                                                                                           |       | (2,414             | )          | —                |       |
| Warrants outstanding                                                                                                    |       | 1,099              |       | 1,099                 |       |
| Deferred compensation                                                                                                   |       | (73                | )          | (347                  | )          |
| Accumulated other comprehensive income                                                                                  |       | 782                |       | 926                   |       |
| Accumulated deficit                                                                                                     |       | (217,700           | )          | (200,866              | )          |
| Total stockholders’ equity                                                                                         |       | 28,152             |       | 19,516                |       |
|                                                                                                                    |       |               |       |                  |       |
| Total liabilities and stockholders’ equity                                                                         |       | $                  | 73,232     |                  | $          | 94,952 |   |

 

See notes to condensed consolidated financialstatements.

 

3

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**THESCO GROUP, INC. AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)**

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

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

 

See notes to condensed consolidated financialstatements.

 

4

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**THESCO GROUP, INC. AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited, in thousands)**

 
| ** **                                                                                          | ** ** | **Nine Months Ended July 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                          | ** ** | **2004**                       | ** ** | **2003** | ** ** |
|                                                                                                |       |                           |       |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                               |       |                           |       |   |   |
| Net income (loss)                                                                                   |       | $                              | (16,834    | ) | $ | 6,872 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                           |       |   |   |
| Change in fair value of derivative                                                                  |       | (5,924                         | )          | — |   |
| Loss on impairment of long-lived assets                                                             |       | 2,139                          |       | — |   |
| Amortization of intangibles (including $250  and $253 classified as cost of revenue)                |       | 2,223                          |       | 2,548 |   |
| Depreciation and other amortization                                                                 |       | 629                            |       | 815 |   |
| Stock-based compensation                                                                            |       | 868                            |       | 927 |   |
| Equity in (income) losses of affiliates                                                             |       | (115                           | )          | 171 |   |
| Issuance of a warrant included as cost of  SCOsource licensing revenue                              |       | —                         |       | 94 |   |
| Changes in operating assets and liabilities                                                         |       |                           |       |   |   |
| Accounts receivable, net                                                                            |       | 3,328                          |       | 1,047 |   |
| Other current assets                                                                                |       | (16                            | )          | 854 |   |
| Other assets                                                                                        |       | (204                           | )          | 1,140 |   |
| Accounts payable                                                                                    |       | (153                           | )          | (407 | ) |
| Accrued payroll and benefits                                                                        |       | (1,677                         | )          | (325 | ) |
| Accrued compensation to law firms                                                                   |       | (2,600                         | )          | — |   |
| Accrued liabilities                                                                                 |       | 6,995                          |       | (2,286 | ) |
| Deferred revenue                                                                                    |       | 435                            |       | (3,234 | ) |
| Other royalties payable                                                                             |       | (352                           | )          | (1 | ) |
| Taxes payable                                                                                       |       | 562                            |       | 137 |   |
| Long-term liabilities                                                                               |       | (7                             | )          | (1,576 | ) |
| Net cash provided by (used in) operating  activities                                                |       | (10,703                        | )          | 6,776 |   |
|                                                                                                |       |                           |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                               |       |                           |       |   |   |
| Purchase of property and equipment                                                                  |       | (331                           | )          | (524 | ) |
| Purchase of available-for-sale securities                                                           |       | (28,866                        | )          | — |   |
| Proceeds from available-for-sale securities                                                         |       | 5,756                          |       | — |   |
| Purchase of minority interest in Japanese  subsidiary                                               |       | (209                           | )          | — |   |
| Investment in non-marketable securities                                                             |       | —                         |       | (950 | ) |
| Net cash used in investing activities                                                               |       | (23,650                        | )          | (1,474 | ) |
|                                                                                                |       |                           |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                               |       |                           |       |   |   |
| Proceeds from sale of common stock through  ESP program                                             |       | 810                            |       | 236 |   |
| Costs incurred in connection with Series  A-1 issuance                                              |       | (211                           | )          | — |   |
| Repurchase and retirement of Series A-1  convertible preferred stock                                |       | (13,000                        | )          | — |   |
| Purchase of common stock                                                                            |       | (2,414                         | )          | — |   |
| Net proceeds from the issuance of a warrant                                                         |       | —                         |       | 650 |   |
| Proceeds from exercise of common stock  options                                                     |       | 591                            |       | 1,443 |   |
| Net cash provided by (used in) financing  activities                                                |       | (14,224                        | )          | 2,329 |   |
|                                                                                                |       |                           |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                                               |       | (48,577                        | )          | 7,631 |   |
| EFFECT OF FOREIGN EXCHANGE RATES ON CASH                                                            |       | 131                            |       | 441 |   |
| CASH AND CASH EQUIVALENTS, beginning of period                                                      |       | 64,428                         |       | 6,589 |   |
| CASH AND CASH EQUIVALENTS, end of period                                                            |       | $                              | 15,982     |   | $ | 14,661 |   |
|                                                                                                |       |                           |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:                                                  |       |                           |       |   |   |
|                                                                                                |       |                           |       |   |   |
| Cash paid for taxes                                                                                 |       | $                              | 652        |   | $ | 297 |   |
|                                                                                                |       |                           |       |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING  AND FINANCING ACTIVITIES:                               |       |                           |       |   |   |
|                                                                                                |       |                           |       |   |   |
| Accretion of dividends                                                                              |       | $                              | 2,047      |   | $ | — |   |
|                                                                                                |       |                           |       |   |   |
| Capital contribution in connection with  repurchase and cancellation of Series A-1 shares           |       | $                              | (15,475    | ) | $ | — |   |
|                                                                                                |       |                           |       |   |   |
| Dividend in connection with exchange of  Series A-1 for Series A                                    |       | $                              | 6,305      |   | $ | — |   |
|                                                                                                |       |                           |       |   |   |
| Acquisition of Vultus, Inc.:                                                                        |       |                           |       |   |   |
| Common stock issued                                                                                 |       | $                              | —     |   | $ | 2,461 |   |
| Accrued liabilties assumed                                                                          |       | $                              | —     |   | $ | 215 |   |

 

See notes to condensed consolidated financialstatements.

 

5

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

 

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

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

 

The business of The SCOGroup, Inc. (the “Company”) focuses on marketing reliable, cost-effective UNIXsoftware products and related services for the small-to-medium sized businessmarket.  In January 2003, the Companyestablished its SCOsource business and launched its first of several SCOsourceinitiatives to review and enforce its intellectual property surrounding theUNIX operating system. The Company acquired certain intellectual propertyrights surrounding UNIX and UNIX System V source code from The Santa CruzOperation (now Tarantella, Inc.) in May 2001.

 

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

 

### **Basis ofPresentation**

 

The accompanying unaudited condensed consolidatedfinancial statements of the Company have been prepared by the Company pursuantto the rules and regulations of the Securities and Exchange Commission (“SEC”)on a basis consistent with the Company’s audited annual financial statementsand, in the opinion of management, reflect all adjustments, consisting ofnormal recurring adjustments, necessary to present fairly the financialinformation set forth therein.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted pursuant to SEC rulesand regulations, although the 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 ninemonths ended July 31, 2004 are not necessarily indicative of the results thatmay be expected for the year ending October 31, 2004.

 

### **Use of Estimatesin the Preparation of Financial Statements**

 

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

 

### **RevenueRecognition**

 

The Company recognizes revenue in accordance withStatement of Position (“SOP”) 97-2, as modified by SOP 98-9, and StaffAccounting Bulletin (“SAB”) No. 104. Revenue recognition in accordance with these pronouncements can becomplex due to the nature and variability of the Company’s sales transactions.  The Company’s revenue is primarily from threesources: (i)

 

6

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productlicense revenue, primarily from product sales to resellers and end users, androyalty revenue from product sales to original equipment manufacturers(“OEMs”); (ii) service and support revenue, primarily from providing support,education and consulting services to end users; and (iii) licensing revenuefrom its SCOsource intellectual property initiative.

 

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

 

The majority of the Company’s revenue transactionsrelate to product-only sales.  Onoccasion, the Company has revenue transactions that have multiple elements(such as delivered and undelivered products, maintenance and otherservices).  For software agreements thathave multiple elements, the Company allocates revenue to each component of thecontract based on the relative fair value of the elements.  The fair value of each element is based onvendor specific objective evidence (“VSOE”). VSOE is established when such elements are sold separately.  The Company recognizes revenue allocated toundelivered products when the criteria for product revenue recognition setforth above have been met.  If VSOE ofall undelivered elements exists, but VSOE does not exist for one or moredelivered elements, then revenue is recognized using the residual method.  Under the residual method, the fair value ofthe undelivered elements is deferred and recognized in future periods and theremaining portion of the license fee is recognized in the current period asproduct revenue.

 

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

 

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

 

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

 

The Company accounts for stock options issued to directors,officers and employees under Accounting Principles Board (“APB”) No. 25.  Under APB No. 25, compensation expense isrecognized if an option’s exercise price on the measurement date is below thefair market value of the Company’s common stock.

 

Statements of Financial Accounting Standards (“SFAS”)No. 148, “Accounting for Stock-Based Compensation,” requires pro formainformation regarding net income (loss) to common stockholders asif the Company had accounted for its stock options granted under the fair valuemethod.  The fair value for the Company’sstock options is estimated on the date of grant using the Black-Scholesoption-pricing model.

 

Withrespect to stock options, restricted stock awards granted and employee stockpurchase program (“ESPP”) shares purchased during the three and nine monthsended July 31, 2004 and 2003, the assumptions used are listed in the followingtable:

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

 

7

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

 
| ** **                                                                     | ** ** | **Three Months Ended July 31,** | ** ** | **Nine Months Ended July 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                        | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                           |       |                            |       |                           |       |   |   |   |   |
| Net income (loss) applicable to common  stockholders:                          |       |                            |       |                           |       |   |   |   |   |
| As reported                                                                    |       | $                               | 7,501      |                           | $          | 3,096 |   | $ | (9,711 | ) | $ | 6,872 |   |
| Stock-based compensation as reported                                           |       | 270                             |       | 309                            |       | 868 |   | 927 |   |
| Stock-based compensation under fair value  method                              |       | (197                            | )          | (507                           | )          | (1,126 | ) | (1,446 | ) |
| Pro forma net income (loss)                                                    |       | $                               | 7,574      |                           | $          | 2,898 |   | $ | (9,969 | ) | $ | 6,353 |   |
|                                                                           |       |                            |       |                           |       |   |   |   |   |
| Net income (loss) applicable to common  stockholders per diluted common share: |       |                            |       |                           |       |   |   |   |   |
| As reported                                                                    |       | $                               | 0.38       |                           | $          | 0.19 |   | $ | (0.67 | ) | $ | 0.47 |   |
| Pro forma                                                                      |       | $                               | 0.38       |                           | $          | 0.18 |   | $ | (0.69 | ) | $ | 0.43 |   |

 

**Cash and Cash Equivalents and Available-for-SaleSecurities**

 

The Company considers all highly liquid debtinstruments purchased with original maturities of three or fewer months to becash equivalents.  Cash equivalents were$12,565,000 as of July 31, 2004 and $61,701,000 as of October 31, 2003, whichprimarily consisted of investments in money market funds, commercial paper,corporate notes and agencies.

 

Available-for-salesecurities consist primarily of securities that either mature within the next 12months or have characteristics of short-term investments.  All available-for-sale securities areavailable for working capital purposes as necessary.  Available-for-sale securities are recorded atfair market value based on quoted market prices and any unrealized gains andlosses are included as a component of other comprehensive income untilrealized.  Any declines in market valuethat are considered to be other than temporary are charged to earnings.

 

**Net Income (Loss) per Common Share**

 

Basic net income (loss) per common share (“Basic EPS”)is computed by dividing net income (loss) by the weighted average number ofcommon shares outstanding.  Diluted netincome (loss) per common share (“Diluted EPS”) is computed by dividing netincome (loss) by the sum of the weighted average number of common sharesoutstanding and the dilutive potential common share equivalents thenoutstanding.  Potential common shareequivalents consist of the weighted average of shares issuable upon theexercise of outstanding stock options, restricted stock awards, warrants to acquire common stock and preferred stock convertible intocommon shares.   The excludedanti-dilutive common share equivalents are not included in the computation ofDiluted EPS as their effect would have decreased Diluted EPS.

 

8

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

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

 

**Reclassifications**

 

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

 

**(3) GOODWILL AND INTANGIBLE ASSETS**

 

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

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

 

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

 

The Company recorded a loss on impairment oflong-lived assets totaling $2,139,000, which related to animpairment on intangible assets of $973,000 and an impairment ofgoodwill of $1,166,000 for the nine months ended July 31, 2004.  The impairment related to goodwill and

 

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intangibleassets acquired in connection with the acquisition of Vultus, Inc. (“Vultus”)in June 2003.  The Company concluded thatan impairment-triggering event occurred during the three months ended April 30,2004 as an impending partnership that would solidify the Vultus revenue andcash flow opportunities did not materialize. Additionally, the Company had a reduction in force that impacted theCompany’s ability to move the Vultus initiative forward on a stand-alone basis.  Consequently, the Company has concluded thatno significant future cash flows related to its Vultus assets would berealized.  The Company performed animpairment analysis of its recorded goodwill related to the Vultus reportingunit in accordance with SFAS No. 142. Additionally, an impairment analysis of the intangible assets wasperformed in accordance with SFAS No. 144. As a result of these analyses, the Company wrote-down the carrying valueof its goodwill related to the Vultus acquisition from $1,166,000 to $0 andwrote-down intangible assets related to its Vultus acquisition from $973,000 to$0.

 

**(4) RESTRUCTURING PLANS**

 

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

 

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

 

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

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

 

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

 

**(5)  REDEEMABLECONVERTIBLE PREFERRED STOCK**

 

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

 

The terms of the Series A included a number ofconversion provisions that represented a derivative financial instrument underSFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities.”  The Company determined thatthe conversion feature allowing Series A holders toacquire common shares was an embedded derivative that did not qualify as ascope exemption under the provisions of EITF 00-19, “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in a Company’s OwnStock.”  This required the Company toseparately account for and record at fair value and mark-to-market the fairvalue of the

 

10

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derivative.  Changes in the fair value of the derivativewere recorded in the Company’s statement of operations.  As of October 16, 2003, the Company, throughthe assistance of an independent valuation firm, determined the initial fairvalue of the derivative was $18,069,000. As of October 31, 2003, the fair value of the derivative was $15,224,000and the decrease in fair value of $2,845,000 was recorded as change in fairvalue of derivative in other income in the statement of operations for fiscalyear 2003.

 

As of January 31, 2004, the fair value of thederivative was $11,600,000, and the decrease in fair value of $3,624,000 wasrecorded as change in fair value of derivative in other income in the statementof operations for three months ended January 31, 2004.   On February 5, 2004, all outstanding SeriesA shares were exchanged for shares of the Company’s Series A-1 ConvertiblePreferred Stock (the “Series A-1”), and, as a result, no Series A sharesremained outstanding as of February 5, 2004. The exchange did not result in the Company receiving any additionalproceeds.  As of February 5, 2004, thefair value of the derivative was $9,300,000 and the decrease in fair value of$2,300,000 from January 31, 2004 was recorded as change in fair value ofderivative in other income in the statement of operations for the three monthsended April 30, 2004.

 

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

 

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

 

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

 

**Agreement to Repurchase BayStar CapitalSeries A-1 Shares**

 

On May 31, 2004, the Company entered into an agreementwith BayStar to repurchase and retire BayStar’s 40,000 Series A-1 shares.  Terms of the agreement required the Companyto pay to BayStar $13,000,000 in cash and issue 2,105,263 shares of theCompany’s common stock.  The repurchaseprice was payable and issuable upon the effectiveness of a shelf registrationstatement covering the resale of the shares of common stock that would beissued to BayStar upon the closing of the repurchase.  On July 21, 2004, the SEC declared theCompany’s registration statement on Form S-3 effective, and, in accordance withthe terms of the repurchase agreement, the closing of the repurchase withBayStar closed as of that date (see Note 10). The fair value of the cash and common shares delivered to BayStar wasless than the carrying value of the remaining value of the Series A-1 sharesand the Company recorded a capital contribution for this difference as outlinedin the following table (in thousands):

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

 

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**Dividends**

 

If the repurchase had not occurred, dividends on theSeries A-1 shares would have been paid after October 16, 2004, the firstanniversary of the original Series A private placement, quarterly at a rate of8 percent per annum, subject to annual increases of 2 percent per annum, not toexceed 12 percent per annum.  Althoughthe Company accrued dividends of $551,000 and $2,047,000 for the three and ninemonths ended July 31, 2004, respectively, which reduced earnings to commonstockholders, the Company will no longer accrue dividends on preferred stockbecause the repurchase transaction with BayStar closed.  The Company never paid any dividends on the SeriesA or Series A-1 shares.

 

**(6) COMMITMENTS AND CONTINGENCIES**

 

**Litigation**

 

*IBM Corporation*

 

On or aboutMarch 6, 2003, the Company filed a complaint against IBM Corporation(“IBM”).  The action is currently pendingin the United States District Court for the District of Utah.  The initial complaint included claims forbreach of contract, misappropriation of trade secrets, tortious interference,and unfair competition.  The initialcomplaint also alleged that IBM obtained information concerning the UNIX sourcecode and derivative works from the Company and inappropriately used anddistributed that information in connection with its efforts to promote theLinux operating system.  As a result ofIBM’s actions, the Company is requesting damages in an amount to be proven attrial, together with additional damages through and after the time oftrial.  Additionally, on or about June13, 2003, the Company delivered to IBM a notice of termination of IBM’s UNIXlicense agreement with the Company, which license underlies IBM’s AIX software.

 

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

 

IBM filed a response and counterclaim to thecomplaint, including a demand for a jury trial. The Company has filed an answer to the IBM counterclaim denying theclaims and asserting affirmative defenses. On February 4, 2004, the Company filed a motion for leave to fileamended pleadings in the case proposing to amend its complaint against IBM andto modify its affirmative defenses against IBM’s counterclaims.  On February 25, 2004, the court granted theCompany’s motion for leave to amend.  Thesecond amended complaint, which was filed on February 27, 2004, alleges ninecauses of action that are similar to those set forth above, adds a new claimfor copyright infringement and removes the claim for misappropriation of tradesecrets.  IBM has filed an answer andcounterclaim.  The counterclaim filed byIBM asserts 14 claims against the Company. In its counterclaim, as amended, IBM asserts that the Company does nothave the right to terminate IBM’s UNIX license or assert claims based on theCompany’s ownership of UNIX intellectual property against IBM or others in theLinux community.  In addition, IBMasserts that the Company has breached the GNU General Public License and hasinfringed certain patents held by IBM. IBM’s counterclaims include claims for breach of contract,

 

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violationof the Lanham Act, unfair competition, intentional interference withprospective economic relations, unfair and deceptive trade practices,promissory estoppel, copyright infringement for a declaratory judgment ofnon-infringement of copyrights, and patent infringement.

 

On March 3, 2004, the U.S. Magistrate Judge issuedan order addressing certain discovery matters relating to both the Company andIBM.  The Company filed a motion todismiss IBM’s tenth counterclaim for a declaratory judgment of non-infringementof copyrights.  The Company has alsofiled a motion to amend the scheduling order and a motion to bifurcate IBM’spatent counterclaims into another action. The Company filed, on May 28, 2004, a reply brief in connection with itsmotion to amend the scheduling order, in which the Company sets forth detailedand specific responses to IBM’s claims made in connection with thatmotion.  A hearing for these motions washeld on June 8, 2004, and the court issued its ruling on June 10, 2004.

 

The court granted the Company’s motion to amend thescheduling order, with certain changes. The amended scheduling order now provides, among other things, that thedeadline for completing fact discovery is February 11, 2005 (previously August4, 2004), the deadline for completing expert discovery is April 22, 2005(previously October 22, 2004), and the trial will begin on November 1, 2005(previously April 11, 2005).  The courtalso denied the Company’s motion to bifurcate IBM’s patent counterclaimswithout prejudice to the Company’s right to request a bifurcation again at alater date.  IBM has also filed a motionfor partial summary judgment on its tenth counterclaim for a declaration ofnon-infringement of the Company’s copyrights. A hearing regarding the Company’s motion to dismiss and IBM’s motion forpartial summary judgment on IBM’s tenth counterclaim for a declaration ofnon-infringement is currently scheduled for September 15, 2004.  The Company plans to vigorously oppose IBM’smotion.  The Company has filed variousmotions seeking additional discovery from IBM. IBM has filed two additional motions for summary judgment which theCompany will vigorously oppose.  Inaddition to the materials that have been publicly filed with the court, certaininformation has been filed under seal in accordance with the protective orderentered in the case.

 

*Red Hat, Inc.*

 

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

 

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

 

*Novell, Inc.*

 

On or about January20, 2004, the Company brought suit in Utah state court againstNovell, Inc. (“Novell”) for slander of title seeking relief for Novell’salleged bad faith efforts to

 

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interferewith the Company’s ownership of copyrights related to its UNIX source code andderivative works and its UnixWare product. In the lawsuit, the Company requested preliminary and permanentinjunctive relief as well as damages. Through these claims, the Company seeks to require Novell to assign tothe Company all copyrights that it believes Novell has wrongfully registered,prevent Novell from representing any ownership interest in those copyrights andrequire Novell to retract or withdraw all representations it has made regardingits purported ownership of those copyrights. Novell also filed a motion to dismiss the Company’s complaint claimingit never transferred the copyrights to The Santa Cruz Operation (nowTarantella, Inc.).  The Company filed aresponse to Novell’s motion to dismiss and also filed a motion to remand thecase back to the state court.  On June10, 2004, the court issued a memorandum decision and order which denied theCompany’s motion to remand the case to state court.  The memorandum decision also denied Novell’smotion to dismiss in part on claims of falsity. However, the court granted Novell’s motion to dismiss regarding theCompany’s allegations of special damages, but granted the Company 30 days leaveto amend its complaint to plead special damages with more specificity.  The Company has filed its amended complaintand Novell has responded with another motion to dismiss claiming that Novell’salleged slanderous statements are privileged under the law.  The Company plans to continue to vigorouslypursue its claims against Novell.

 

*DaimlerChrysler Corporation*

 

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

 

*AutoZone, Inc.*

 

On or about March 2, 2004, theCompany brought suit against AutoZone, Inc. (“AutoZone”) for its allegedviolations of the Company’s UNIX copyrights through its use of Linux.  Specifically, the lawsuit alleges thatAutoZone is infringing the Company’s UNIX copyrights by, among other things,running versions of the Linux operating system that contain code, structure,sequence and/or organization from the Company’s proprietary UNIX System V codein violation of its copyrights.  Thelawsuit filed in U.S. District Court in Nevada requests injunctive reliefagainst AutoZone’s further use or copying of any part of the Company’scopyrighted materials and also requests damages as a result of AutoZone’sinfringement in an amount to be proven at trial.  On April 23, 2004, AutoZone filed a motion totransfer the case to Tennessee or to stay the case.  On August 6, 2004, the federal court inNevada entered an order granting AutoZone’s motion to stay the case with 90-daystatus reports to the court.  The courtdenied without prejudice AutoZone’s motion for a more definite statement andits motion to transfer the case to Tennessee. The court also is allowing the parties to take limited expediteddiscovery relating to the issue of preliminary injunctive relief requested bythe Company.  The Company is undertakingthat discovery process.

 

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*IPO Class Action Matter*

 

The Company isan issuer defendant in a series of class action lawsuits involving over 300issuers that have been consolidated under one action.  The plaintiffs, the issuers and the insurancecompanies have negotiated an agreement to settle the dispute between theplaintiffs and the issuers.  All parties,including the plaintiffs, issuers and insurance companies, have executed thissettlement agreement and the settlement agreement has been submitted to thecourt for approval.  If the settlementagreement is approved by the court, and if no cross-claims, counterclaims orthird party claims are later asserted, this action will be dismissed withrespect to the Company and its directors.

 

The Companyhas notified its underwriters and insurance companies of the existence of theclaims.  Management believes, afterconsultation with legal counsel, that the ultimate outcome of this matter willnot have a material adverse effect on the Company’s results of operations orfinancial position.  As of July 31, 2004,the Company has paid or accrued the full retention amount of $200,000 under its insurance coverage.

 

*Other Matters*

 

In April 2003,a former Indian distributor of the Company filed a claim in India, requestingsummary judgment for payment of $1,428,000, and an order that the Company tradein India only through the distributor and/or to give a security deposit untilthe claim is paid.  The distributorclaims that the Company is responsible to repurchase certain software productsand to reimburse the distributor for certain other operating costs.  Management does not believe that the Companyis responsible to reimburse the distributor for any operating costs and alsobelieves that the return rights related to any remaining inventory havelapsed.  Management has engaged localcounsel who has advised it that such claims will likely fail, but that thedistributor will continue to pursue its claims either in the Indian courts orin the U.S. courts.  Discovery hascommenced and hearings have been held and are ongoing.  The Company intends to vigorously defend thisaction.

 

Pursuit anddefense of the above-mentioned matters will be costly, and management expectsthe costs for legal fees and related expenses may 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 including legal proceedings arising from its SCOsourceinitiatives.  Management believes, afterconsultation with legal counsel, that the ultimate outcome of such legalproceedings will not have a material adverse effect on the Company’s results ofoperations or financial position.

 

**Arrangement with Law Firms**

 

On or about February 26, 2003, the Company enteredinto an arrangement with Boies, Schiller & Flexner LLP and other firms toinvestigate and review the Company’s UNIX intellectual property rights.  This arrangement was later modified onNovember 17, 2003 and December 8, 2003. The engagement with the law firms now includes the defense work relatedto counter suits and other retaliatory actions against the Company and lawsuitsagainst end users violating the Company’s intellectual property and contractualrights.  The law firms are alsorepresenting the Company in its lawsuits against IBM, Red Hat, Novell,AutoZone, and DaimlerChrysler.

 

In addition to receiving fees at reduced hourly rates,the Company’s agreement with the law firms provides that the law firms willreceive a contingency fee of 20 percent of the proceeds from specified eventsrelated to the protection of the Company’s intellectual property rights.

 

15

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These events may includesettlements, judgments, licensing fees, subject to certain exceptions, and asale of the Company during the pendancy of litigation or through settlement, subjectto agreed upon credits for amounts received as discounted hourly fees andunused retainer fees.  Additionally, theCompany’s agreement with the law firms may also be construed to includecontingency fee payments in connection with the Company’s issuance of equitysecurities.  Future payments payable tothe law firms under this arrangement may be significant.

 

As described in more detail in Note 10, the Companyand Boies Schiller & Flexner, LLP (“BSF”) have entered into a nonbindingletter of intent to enter into a revised definitive fee agreement.  The revised definitive fee agreement has notyet been completed.

 

**Tax Assessment on the Company’s Indian Branch**

 

During thethree months ended April 30, 2004, the Indian branch of the Company’s UnitedKingdom subsidiary, The SCO Group, Ltd. received a withholding tax assessmentfrom the Government of India Income Tax Department (“Tax Department”) in theamount of $477,000.  In the assessmentthe Tax Department deemed revenue transactions to customers in India as royaltyrevenue which was subject to a 15 percent withholding tax.  The Company believes that the Tax Departmentmay pursue similar assessments for the 2002 and 2003 periods, and has accruedthe full amount of the withholding tax of $314,000 for those periods.  These amounts have been recorded in theCompany’s provision for income taxes during the nine months ended July 31,2004.  Since the initial assessment, theCompany has filed various appeals with the Tax Department objecting to theassessment and will continue to vigorously oppose to the assessment.

 

**(7) STOCKHOLDERS’ EQUITY**

 

**Stock-Based Compensation**

 

The following table details the components ofstock-based compensation for the three and nine months ended July 31, 2004 and2003 (in thousands):

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

 

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

 

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

 

**Options to Consultants**

 

During the three monthsended April 30, 2004, the Company entered into an agreement with a consultantto provide financial consulting and investor relations services to the Company.

 

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The agreement was for a periodof three months and was renewable for additional three-month periods.  The Company paid the consultant a fixed feeof $10,000 per month.  As part of theagreement, the Company granted to the consultant an option to acquire 200,000shares of the Company’s common stock at a price of $10.03 per share, the fairvalue of the Company’s common stock on the date the agreement wasfinalized.    The option expiredunexercised and the agreement with the consultant was not renewed.

 

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

 

**Stock Buyback Program**

 

On March 10,2004, the Company’s board of directors authorized management, in itsdiscretion, to purchase up to 1,500,000 shares of the Company’s common stockover the 24-month period following March 10, 2004, the time at which therepurchase program was effective.  Anyrepurchased shares will be held in treasury and will be available for generalcorporate purposes.  The repurchaseprogram will allow the Company to repurchase its shares from time to time inaccordance with the requirements of the Securities and Exchange Commission onthe open market, in block trades and in privately negotiated transactions,depending on market conditions and other factors.  During the three months ended April 30, 2004,the Company purchased approximately 290,000 shares of its common stock at atotal cost of approximately $2,414,000. There were no repurchases of common stock during the three months endedJuly 31, 2004.

 

**(8) SIGNIFICANT CUSTOMERS**

 

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

 

**(9) SEGMENT INFORMATION**

 

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

 

During fiscal year 2004, in an effort to maximize theassets and resources of the UNIX and SCOsource business segments and to bestrepresent management’s view of business operations, the Company beganallocating resources and reviewing financial information for its UNIX andSCOsource segment.  The following tablepresents the results of the SCOsource segment had it existed during the threeand nine months ended July 31, 2003.  Allcosts associated with the SCOsource segment were classified as cost of revenuefor the three and nine months ended July 31, 2003 and there were no directsales or marketing efforts during these periods.  Segment disclosures for the Company are asfollows for the three and nine months ended July 31, 2004 and 2003 (inthousands):

 

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

 

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

 

| ** **                 | ** ** | **Nine Months Ended July 31, 2004** | ** ** |
|----------------------------|------------|-------------------------------------|------------|
| ** **                 | ** ** | **UNIX**                            | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                       |       |                                |       |   |   |   |   |
| Revenue                    |       | $                                   | 32,025     |   | $ | 709 |   | $ | 32,734 |   |
| Cost of revenue            |       | 5,637                               |       | 15,486 |   | 21,123 |   |
| Gross margin               |       | 26,388                              |       | (14,777 | ) | 11,611 |   |
| Sales and marketing        |       | 12,868                              |       | 1,084 |   | 13,952 |   |
| Research and development   |       | 7,838                               |       | 329 |   | 8,167 |   |
| General and administrative |       | 6,325                               |       | 150 |   | 6,475 |   |
| Other                      |       | 4,980                               |       | — |   | 4,980 |   |
| Total operating expenses   |       | 32,011                              |       | 1,563 |   | 33,574 |   |
| Loss from operations       |       | $                                   | (5,623     | ) | $ | (16,340 | ) | $ | (21,963 | ) |

 

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

 

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The following table presents revenue by geography (inthousands):

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

 

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

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

 

**(10) SUBSEQUENT EVENTS**

 

**BayStar Capital**

 

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

 

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

 

On August 31, 2004, the Companyannounced it had entered into a nonbinding letter of intent with BSF, to revise the existing feeagreement with BSF to limit the Company’s overall future cash costs of legal fees,including accrued legal fees to BSF as of July 31, 2004, associated with theCompany’s pending intellectual property litigation to a total of$31,000,000.  In addition, the nonbinding letter of intent contemplatesthat BSF will lead the Company’s intellectual property legal efforts throughthe duration and completion of the pending litigation.  In return for the new fee arrangement, thenonbinding letter of intent provides that the contingency fee payable to BSFand other law firms associated with any settlement or judgment award will varyon a scaled basis from 20 to 33 percent, depending on the size of theaward.  The revised fee agreement issubject to the Company and BSF entering into a definitive revised feeagreement.

 

**Stockholder Rights Plan**

 

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

 

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Under the terms of the Rights Plan,Series A Junior Participating Preferred Stock purchaserights will be distributed as a dividend at the rate of one right for eachshare of common stock of the Company held by stockholders of record as of theclose of business on August 30, 2004. The Rights Plan would be triggered if a person or group acquired beneficialownership of 15 percent or more of the Company’s common stock other thanpursuant to a board-approved tender or exchange offer or commences, or publiclyannounces 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.

 

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| **ITEM 2****.** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND 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,” andsimilar terms.  Forward-lookingstatements are not guarantees of future performance and our actual results maydiffer significantly 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-Looking Statements” and “Risk Factors” and elsewhere in this Form10-Q.  The following discussion should beread in conjunction with our consolidated financial statements and notesthereto included in this Form 10-Q and our annual report on Form 10-K for theyear ended October 31, 2003 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 nine months ended July31, 2004.  We assume no obligation torevise or update any forward-looking statements for any reason, except asrequired by law.*

 

**Overview**

 

*Historical Background.** *We originallyincorporated as Caldera Systems, Inc., a Utah corporation (“Caldera Systems”),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 holding company in Delaware under the name of CalderaInternational, Inc. to acquire substantially all of the assets and operationsof the server and professional services groups of The Santa Cruz Operation (nowTarantella, Inc.).  In connection withthis acquisition, Caldera Systems became a wholly-owned subsidiary of CalderaInternational, Inc.  Formerholders of shares and options to purchase shares of Caldera Systems received anequal number of shares and options to purchase shares in CalderaInternational, Inc.  On May 16, 2003, our stockholders approvedour corporate name change to The SCO Group, Inc.

 

*Recent Developments.* OnAugust 31, 2004, we announced we had entered into a nonbinding letter of intent with Boies,Schiller & Flexner, LLP (“BSF”), to revise the existing fee agreement withBSF to limit our overall future cash costs of legal fees, including accruedlegal fees to BSF as of July 31, 2004, associated with our pending intellectualproperty litigation to a total of $31,000,000.  In addition, thenonbinding letter of intent contemplates that BSF will lead our intellectualproperty legal efforts through the duration and completion of the pendinglitigation.  In return for the new feearrangement, the nonbinding letter of intent provides that the contingency feepayable to BSF and other law firms associated with any settlement or judgmentaward will vary on a scaled basis from 20 to 33 percent, depending on the sizeof the award.  The revised fee agreementis subject to the Company and BSF entering into a definitive revised feeagreement.

 

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

 

Underthe terms of the Rights Plan, preferred stock purchase rights will bedistributed as a dividend at the rate of one right for each share of commonstock of the Company held by stockholders of record as of the close of businesson August 30, 2004.  The Rights Planwould be triggered if a person or group acquired beneficial ownership of 15percent or more of our common stock other than pursuant to a board-approvedtender or exchange offer or commences,

 

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or publiclyannounces an intention to commence, a tender or exchange offer uponconsummation of which such person or group would beneficially own 15 percent ormore of our common stock.  The adoptionof the Rights Plan had no impact on the financial statements for the thirdquarter or first three quarters of fiscal year 2004.  However, if a triggering event occurs in thefuture, there may be an impact to the financial statements at the time atriggering event occurs.

 

On May 31, 2004, we entered into an agreement with BayStar torepurchase and retire BayStar’s 40,000 Series A-1 shares.  Terms of the agreement required us to pay toBayStar $13,000,000 in cash and issue 2,105,263 shares of our common stock,which consideration was payable and issuable upon closing, which was theeffectiveness of a registration statement covering the resale of the commonstock issued to BayStar.  Theregistration statement was declared effective by the SEC on July 21, 2004, thetransaction closed as of that date, all Series A-1 shares were cancelled andretired and the rights and preferences of the Series A-1 shares wereterminated.  The transaction alsoeliminated BayStar’s contractual rights and includes a general release by bothparties.  The Company delivered the$13,000,000 in cash and 2,105,263 common shares to BayStar on August 24, 2004.

 

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

 

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

 

With respect to our legal action against IBM,on March 3, 2004, the U.S. Magistrate Judge issued an order addressing certaindiscovery matters relating to both IBM and us. We filed a motion to dismiss IBM’s tenth counterclaim for a declaratoryjudgment of non-infringement of copyrights and a motion to amend the schedulingorder and a motion to bifurcate IBM’s patent counterclaims into anotheraction.  We filed, on May 28, 2004, areply brief in connection with its motion to amend the scheduling order, inwhich we set forth detailed and specific responses to IBM’s claims made inconnection with that motion.  A hearingfor these motions was held on June 8, 2004, and the court issued its ruling onJune 10, 2004.  The court granted ourmotion to amend the scheduling order, with certain changes.  The amended scheduling order now provides,among other things, that the deadline for completing fact discovery is February11, 2005 (previously August 4, 2004), the deadline for completing expertdiscovery is April 22, 2005 (previously October 22, 2004), and the trial willbegin on November 1, 2005 (previously April 11, 2005).  The court also denied our motion to bifurcateIBM’s patent counterclaims without prejudice to our right to request abifurcation again at a later date.  IBMhas also filed a motion for partial summary judgment on its tenth counterclaimfor a declaration of non-infringement of our copyrights.  A hearing regarding our motion to dismiss andIBM’s motion for partial summary judgment on IBM’s tenth counterclaim for adeclaration of non-infringement is currently scheduled for September 15,2004.  We plan to vigorously oppose IBM’smotion.  The Company has filed variousmotions seeking additional discovery from IBM. IBM has filed two additional motions for summary judgment which theCompany will vigorously oppose.  Inaddition to the materials that have been publicly filed with the court, certaininformation has been filed under seal in accordance with the protective orderentered in the case.

 

On or about January 20, 2004, we broughtsuit against Novell, Inc. (“Novell”) for slander of title seeking relieffor Novell’s alleged bad faith efforts to interfere with our ownership ofcopyrights related to our UNIX source code and derivative works and ourUnixWare product.  In the lawsuit,

 

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werequest preliminary and permanent injunctive relief as well as damages. Throughour claims, we seek to require Novell to assign to us all copyrights that webelieve Novell has wrongfully registered, prevent Novell from representing anyownership interest in those copyrights and require Novell to retract orwithdraw all representations it has made regarding its purported ownership ofthose copyrights.  On June 10, 2004, thecourt issued a memorandum decision and order which denied our motion to remandthe case to state court.  The memorandumdecision also denied Novell’s motion to dismiss in part on claims offalsity.  However, the court grantedNovell’s motion to dismiss regarding our allegations of special damages, butgranted us 30 days leave to amend our complaint and plead special damages withmore specificity.  The Company has filedits amended complaint and Novell has responded with another motion to dismissclaiming that Novell’s alleged slanderous statements are privileged under thelaw.

 

On or about March 2, 2004, we brought suitagainst AutoZone, Inc. for its alleged violations of our UNIX copyrightsthrough its use of Linux.  Specifically,the lawsuit alleges that AutoZone is infringing our UNIX copyrights by, amongother things, running versions of the Linux operating system that contain code,structure, sequence and/or organization from our proprietary UNIX System V codein violation of our copyrights.  The lawsuitfiled in U.S. District Court in Nevada requests injunctive relief againstAutoZone’s further use or copying of any part of our copyrighted materials andalso requests damages as a result of AutoZone’s infringement in an amount to beproven at trial.  On April 23, 2004,AutoZone filed a motion to transfer the case to Tennessee or to stay thecase.  On August 6, 2004, the federalcourt in Nevada entered an order granting AutoZone’s motion to stay the casewith 90 days status reports to the court. The court denied without prejudice AutoZone’s motion for a more definitestatement and its motion to transfer the case to Tennessee.  The court also is allowing the parties totake limited expedited discovery relating to the issue of preliminaryinjunctive relief requested by us.  Weare undertaking that discovery process.

 

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

 

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

 

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**Business Focus**

 

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

 

*UNIX Business.** *Our UNIXbusiness serves the needs of small-to-medium sized businesses, includingreplicated site franchisees of Fortune 1000 companies, by providing reliable,cost effective UNIX operating systems and software products to power computersrunning on Intel architecture.  Ourlargest source of UNIX business revenue is derived from existing customersthrough our worldwide, indirect, leveraged channel of partners which includesdistributors and independent solution providers.  We have local offices in a number ofcountries that provide support and services to customers and resellers in thesecountries.  The other principal channelfor selling and marketing our UNIX products is through existing customers thathave a large number of replicated sites or franchisees.  We access these corporations through theirinformation technology or purchasing departments with our Area Sales Managersin the United States and through our reseller channel in countries outside theUnited States.  In addition, we also sellour operating system products to OEMs. Our sales of UNIX products and services during the third quarter andfirst three quarters of fiscal year 2004 were primarily to pre-existing UNIXcustomers, and not newly acquired customers. Our UNIX business revenue depends significantly on our ability to marketour products to existing customers and to generate upgrades from existingcustomers.  The following table shows theoperating results of the UNIX business for the three and nine months ended July31, 2004 and 2003 (in thousands):

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

 

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

 

Inan effort to attain profitability in our UNIX business, we have decreased our operatingcosts and increased our gross margin percentage over the last twoquarters.  Operating costs for our UNIXbusiness decreased from $12,111,000 for the third quarter of fiscal year 2003to $8,725,000 for the third quarter of fiscal year 2004, and decreased from$34,808,000 for the first three quarters of fiscal year 2003 to $32,011,000 forthe first three quarters of fiscal year 2004. These cost reductions have primarily been attributable to reducedheadcount and continued operational efficiencies generated in our UNIXbusiness.  We have reduced the number of

 

24

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employeesin our UNIX business from 324 as of July 31, 2003 to 223 as of July 31, 2004,eliminated redundant facilities and reduced other discretionary spending whilestill preserving our worldwide infrastructure. During the fourth quarter of fiscal year 2004, we plan to takeadditional cost reduction actions, which will include reductions in staff as wellas certain reductions and consolidation in office space, which will furtherdecrease the operating costs of our UNIX business.  We estimate that the restructure costassociated with these actions may be approximately $2,000,000, but the actualcost associated with these actions may differ from this estimate.

 

Ourgross margin percentage from our UNIX business also increased from 79 percentin the third quarter of fiscal year 2003 to 85 percent in the third quarter offiscal year 2004.  We may not be able tosustain profitability in our UNIX business through additional operating costreductions.

 

Thedecline in our UNIX business revenue may be accelerated if industry partnerswithdraw their support as a result of our SCOsource initiatives and inparticular any lawsuits against end users violating our intellectual propertyand contractual rights.  The decline inour UNIX business and our SCOsource initiatives, particularly lawsuits againstsuch end users, 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 our UNIX products and services revenue.

 

Animportant initiative for our UNIX business for the 2004 fiscal year has beenour continued investment in and commitment to our UNIX operating systems.  As part of this initiative, we released a newversion of our UnixWare operating system in June 2004 and anticipate releasinga new version of our OpenServer operating system in the first calendar quarterof 2005 and will provide these products with increased system reliability,backward compatibility with existing applications and software, increasedapplication and hardware support, integration with widely used internetapplications and increased system performance.  These enhancements will not have a direct impact on our short-term UNIXrevenue because of the long adoption cycle for new operating system purchasesand our long operating system product sales cycle, but we believe that theywill help prolong our UNIX revenue stream for future quarters.

 

*SCOsource Business.** *During the 2003 fiscal year, webecame aware that our UNIX code and derivative works had been inappropriatelyincluded in the Linux operating system. We believe the inclusion of our UNIX code and derivative works in Linuxhas been a major contributor to the decline in our UNIX business because usersof Linux generally do not pay for the operating system but only minimal fees,if any, for service and maintenance.  TheLinux operating system competes directly with our OpenServer and UnixWareproducts and has taken significant market share from these products.

 

In an effortto protect our UNIX intellectual property, we initiated our SCOsource licensinginitiatives.  These initiatives nowinclude seeking to enter into license agreements with UNIX vendors and offeringSCOsource intellectual property (“IP”) licenses to Linux end users allowingthem to continue to use our UNIX source code and derivative works found inLinux.  Our SCOsource efforts resulted inthe execution of two significant vendor license agreements during fiscal year2003.

 

During fiscal year 2004, we began allocating resourcesand reviewing financial information for SCOsource business.  The following table shows the results ofoperations for the SCOsource business for the third quarter and first threequarters of fiscal year 2004 as well as for the third quarter and first threequarters of fiscal year 2003 had the SCOsource business existed.  There were no direct costs associated with selling,marketing, research and development and

 

25

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generaland administration for the 2003 periods. The following table shows the operating results of the SCOsourcebusiness for the three and nine months ended July 31, 2004 and 2003 (inthousands):

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

 

Our futuresuccess with our SCOsource initiatives and future revenue from SCOsourcelicenses will depend on our ability to protect our UNIX intellectualproperty.   We will continue to devoteresources to our SCOsource initiatives, but we expect quarterly legal fees andother SCOsource related costs to vary from quarter to quarter depending uponthe level of, and activity surrounding, our intellectual property claims, andtherefore are difficult to predict.  Asexplained above in this Item 2 under the caption “Recent Developments,” we haveentered into a nonbinding letter of intent with BSF, our outside litigationlegal counsel, to revise the existing fee agreement with BSF.  Upon completing the revised agreement, weexpect we will limit our future cash costs of legal fees, including accruedlegal fees to BSF as of July 31, 2004, associated with our pending intellectualproperty litigation to a total of $31,000,000. In addition, the nonbinding letter of intent contemplates that thecontingency fee payable to BSF and other law firms associated with anysettlement or judgment award, which is currently set at 20 percent, will varyon a scaled basis from 20 to 33 percent, depending on the size of theaward.  Events that may trigger acontingency fee may include settlements, judgments, licensing fees, subject tocertain exceptions, and a sale of our company during the pendancy of litigationor through settlement, subject to agreed upon credits for amounts received asdiscounted hourly fees and unused retainer fees.  Additionally, our current agreement with ourlaw firms may also be construed to include contingency fee payments inconnection with any issuance of our equity securities, although we intend toeliminate this contingency in the revised fee agreement.  The revised fee agreement is subject to BSFentering into a definitive revised fee agreement with us.

 

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

 

**Critical Accounting Policies**

 

Our critical accountingpolicies and estimates include the following:

 

•                              Revenuerecognition;

 

26

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•                              Deferredincome taxes and related valuation allowances;

 

•                              Fair valueof derivative financial instrument and our now retired Series A-1 ConvertiblePreferred Stock;

 

•                              Impairmentof long-lived assets; and

 

•                              Allowancesfor doubtful accounts.

 

*RevenueRecognition*.  Werecognize revenue in accordance with Statement of Accounting Position (“SOP”)97-2, as amended, and Staff Accounting Bulletin (“SAB”) 104.  Revenue recognition in accordance with thesepronouncements can be complex due to the nature and variability of our salestransactions.  We recognize productsrevenue and SCOsource revenue upon shipment if a signed contract exists, thefee is fixed and determinable, collection of the resulting receivable isprobable and product returns are reasonably estimable, except for sales todistributors, which are recognized upon sale by the distributor to resellers orend users.  We recognize product revenuefrom royalty payments upon receipt of quarterly royalty reports from OEMsrelated to their product sales.

 

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

 

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

 

*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 bedetermined.  We have provided a valuationallowance of $52,908,000 against our entire net deferred tax asset as ofOctober 31, 2003.  The valuationallowance was recorded because of our history of net operating losses and theuncertainties regarding our future operating profitability and taxable income.

 

*FairValue of Derivative Financial Instrument and Our Retired Series A-1 ConvertiblePreferred Stock*. On October 16, 2003, we issued 50,000 shares of our redeemable Series A Convertible Preferred Stock for $1,000 per share.  The net proceeds from the sale of thepreferred stock were $47,740,000.  Theterms of the preferred stock included conversion and a number of redemption provisionsthat represented a derivative financial instrument under SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities,” asamended.  We determined that theconversion feature allowing the holders of the preferred stock to acquirecommon shares is an embedded derivative financial instrument that does not qualifyas a scope exemption under the provisions of Emerging Issues Task Force(“EITF”) 00-19, “Accounting for Derivative Financial Instruments Indexed to,and Potentially Settled in a Company’s Own Stock.”

 

27

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As of October 16, 2003, through the assistance of anindependent valuation firm, we determined the initial fair value of thederivative was $18,069,000 and the value of the preferred stock was$29,671,000.  We were required to accountfor the conversion feature as an embedded derivative since the preferred stockinstrument did not entitle the holders to equity features such as voting rightsand board representation.  As of October31, 2003, the fair value of the derivative was $15,224,000 and the decrease infair value of $2,845,000 was recorded as change in fair value of derivative inother income in the statement of operations for fiscal year 2003.  As of January 31, 2004, the fair value of thederivative was $11,600,000 and the decrease in fair value of $3,624,000 wasrecorded as change in fair value of derivative in other income in our condensedconsolidated statement of operations for the three months ended January 31,2004.

 

On February 5,2004, we completed an exchange transaction in which each outstanding Series A share was exchanged for one share of redeemable Series A-1Convertible Preferred Stock.  We receivedno additional proceeds in the exchange. The exchange transaction eliminated the derivative related to the SeriesA shares that was initially recorded as a current liability on our balancesheet and eliminated the charge in our quarterly statements of operations forthe change in the fair value of the derivative related to the Series Ashares.  The derivative was eliminateddue to certain rights and privileges included in the new Series A-1 shares,such as voting rights and rights to board representation, among others, thatwere not included in the Series A shares.

 

We recorded $2,300,000 as change in fair value ofderivative in other income in the second quarter of fiscal year 2004 related tothe change in the fair value of the derivative between January 31, 2004 andFebruary 5, 2004, the time at which the exchange agreement was executed.  Through the assistance of an independentvaluation firm, we determined the fair value of the Series A-1 shares to be$45,276,000 as of February 5, 2004.  Werecorded a dividend in the second quarter of fiscal year 2004 of $6,305,000related to the difference between the fairvalue of the Series A-1 shares and the carrying value of the previously issuedSeries A shares and related derivative. This dividend reduced earnings to common stockholders.  The estimated fair value of the Series A-1shares as of February 5 was calculated using a binomial model.  Specific assumptions used included: 2.7 yearsto maturity, 11 percent equivalent bond yield, risk-free rate of 2.4 percent,volatility of 130 percent.  As describedelsewhere in this filing, we repurchased all outstanding Series A-1 shares onJuly 21, 2004.

 

*Impairmentof Long-lived Assets*. We review our long-lived assets for impairment when events or changes incircumstances indicate that the book value of an asset may not berecoverable.  We evaluate, at each balancesheet date, whether events and circumstances have occurred which indicatepossible impairment.  The carrying valueof a long-lived asset is considered impaired when the anticipated cumulativeundiscounted cash flows of the related asset or group of assets is less thanthe carrying value.  In that event, aloss is recognized based on the amount by which the carrying value exceeds theestimated fair market value of the long-lived asset.

 

We performed an impairment analysis as of April 30,2004 in accordance with SFAS No. 142, “Goodwill and Other IntangibleAssets”  and SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” and determined that thegoodwill and intangible assets related to the Vultus technology, which weacquired from Vultus, Inc. (“Vultus”) in June 2003, had been impaired.  We concluded that an impairment-triggeringevent occurred during the second quarter of fiscal year 2004 as an impendingpartnership that would solidify the Vultus revenue and cash flow opportunitiesdid not materialize.  Additionally, wehad a reduction in force that impacted our ability to move the Vultusinitiative forward on a stand-alone basis. Consequently, we have concluded that no significant future cash flowsrelated to our Vultus assets would be realized. As a result of these analyses, we wrote-down the carrying value of our

 

28

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goodwillrelated to the Vultus acquisition from $1,166,000 to $0 and wrote-downintangible assets related to our Vultus acquisition from $973,000 to $0.

 

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

 

*Allowance for Doubtful Accounts*.  Weoffer credit terms on the sale of our products to a majority of our customersand require no collateral from these customers. We perform ongoing credit evaluations of our customers’ financialcondition and maintain an allowance for doubtful accounts based upon ourhistorical collection experience and expected collectibility of all accountsreceivable and have applied these policies consistently throughout the threeand nine months ended July 31, 2004.  Ourallowance for doubtful accounts, which is determined based on our historical experienceand a specific review of customer balances, was $126,000 as of July 31,2004.  Our past experience has resultedin minimal differences from the actual amounts provided for bad debts and ourrecorded estimates.  However, our actualbad debts in future periods may differ from our current estimates and thedifferences may be material, which may have an adverse impact on ourfuture accounts receivable and cash position.

 

**Results of Operations**

 

The followingtable presents our results of operations for the three and nine months endedJuly 31, 2004 and 2003 (in thousands):

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

 

29

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

 

*Revenue*

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

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

 

Revenuefor the third quarter of fiscal year 2004 decreased by $8,850,000 or 44percent, from the third quarter of fiscal year 2003, and revenue for the firstthree quarters of fiscal year 2004 decreased by $22,230,000 or 40 percent, fromthe first three quarters of fiscal year 2003. These decreases were primarily attributable to decreased revenue fromour UNIX products and services as a result of competition from other operatingsystems, primarily Linux, and minimal SCOsource licensing revenue in the firstthree quarters of fiscal year 2004 compared to SCOsource revenue of $7,280,000in the third quarter of fiscal year 2003 and SCOsource revenue of $15,530,000in the first three quarters of fiscal year 2003.

 

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

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

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

 

The decreasein revenue in the UNIX business for the third quarter and first three quartersof fiscal year 2004 compared to the third quarter and first three quarters offiscal year 2003 was primarily attributable to continued competition from otheroperating systems, particularly Linux, as well as a decrease in revenue fromcorporate accounts and a decrease from our distribution channel.  We anticipate for the fourth quarter of 2004fiscal year that total UNIX revenue will be consistent with or slightly lowerthan revenue generated in the third quarter of fiscal year 2004.

 

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

 

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

 

*Products Revenue*

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

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

 

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

 

The decreasein products revenue in the third quarter and first three quarters of fiscalyear 2004 as compared with the third quarter and first three quarters of fiscalyear 2003 was primarily attributable to decreased sales of UnixWare andOpenServer products primarily resulting from increased competition in theoperating system market, particularly Linux, and from a decrease in informationtechnology spending for UNIX products compared to other operating systemproducts.  This negative impact was feltin all of our distribution channels, and we believe that the competition fromLinux will continue in future periods.

 

Our productsrevenue was derived primarily from sales of our OpenServer and UnixWareproducts.  Other products revenueconsists mainly of product maintenance and other UNIX-related products.  Revenue for these product lines was asfollows:

 

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| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| OpenServer revenue          |       | $                               | 4,496,000  |   | (14 | )% | $ | 5,243,000 |   |
| Percent of products revenue |       | 50                              | %          |   |   | 49 | % |
| UnixWare revenue            |       | 2,984,000                       |       | (14 | )% | 3,452,000 |   |
| Percent of products revenue |       | 34                              | %          |   |   | 32 | % |
| Other products revenue      |       | 1,449,000                       |       | (31 | )% | 2,109,000 |   |
| Percent of products revenue |       | 16                              | %          |   |   | 19 | % |
|                        |       |                            |       |   |   |   |   |
| ** **                  | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| OpenServer revenue          |       | $                               | 14,278,000 |   | (9 | )% | $ | 15,734,000 |   |
| Percent of products revenue |       | 53                              | %          |   |   | 48 | % |
| UnixWare revenue            |       | 8,240,000                       |       | (25 | )% | 10,956,000 |   |
| Percent of products revenue |       | 30                              | %          |   |   | 33 | % |
| Other products revenue      |       | 4,538,000                       |       | (28 | )% | 6,326,000 |   |
| Percent of products revenue |       | 17                              | %          |   |   | 19 | % |

 

Sales of ourOpenServer and UnixWare products as well as other products are primarilygenerated from existing customers.  Asour existing customers have slowed purchasing decisions, decreased purchasinglevels or moved to other operating systems, including Linux, our productsrevenue has declined.

 

*SCOsourceLicensing Revenue*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| SCOsource licensing revenue |       | $                               | 678,000    |   | (91 | )% | $ | 7,280,000 |   |
| Percent of total revenue    |       | 6                               | %          |   |   | 36 | % |
|                        |       |                            |       |   |   |   |   |
| ** **                  | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| SCOsource licensing revenue |       | $                               | 709,000    |   | (95 | )% | $ | 15,530,000 |   |
| Percent of total revenue    |       | 2                               | %          |   |   | 28 | % |

 

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

 

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

 

32

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*Services Revenue*

 
| ** **               | ** ** | **Three Months Ended July 31,** | ** ** |
|--------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                     |       |                            |       |   |   |   |   |
| Services revenue         |       | $                               | 1,598,000  |   | (19 | )% | $ | 1,971,000 |   |
| Percent of total revenue |       | 14                              | %          |   |   | 10 | % |
|                     |       |                            |       |   |   |   |   |
| ** **               | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **               | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                     |       |                            |       |   |   |   |   |
| Services revenue         |       | $                               | 4,969,000  |   | (23 | )% | $ | 6,418,000 |   |
| Percent of total revenue |       | 15                              | %          |   |   | 12 | % |

 

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

 

Servicesrevenue during the third quarter and first three quarters of fiscal year 2004was generated primarily from pre-existing customers.  Our UNIX business services revenue dependssignificantly on our ability to market our services to existing customers.  Additionally, our futurelevel of services revenue depends on our ability to generate UNIX productsrevenue from existing customers and on the renewal of certain annual supportand services agreements with existing customers.

 

*Cost of Products Revenue*

 
| ** **                     | ** ** | **Three Months Ended July 31,** | ** ** |
|--------------------------------|------------|---------------------------------|------------|
| ** **                     | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                           |       |                            |       |   |   |   |   |
| Cost of products revenue       |       | $                               | 741,000    |   | (38 | )% | $ | 1,200,000 |   |
| Percentage of products revenue |       | 8                               | %          |   |   | 11 | % |
|                           |       |                            |       |   |   |   |   |
| ** **                     | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                     | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                           |       |                            |       |   |   |   |   |
| Cost of products revenue       |       | $                               | 2,364,000  |   | (31 | )% | $ | 3,422,000 |   |
| Percentage of products revenue |       | 9                               | %          |   |   | 10 | % |

 

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

 

Forthe fourth quarter of fiscal year 2004, we expect the dollar amount of our costof products revenue to be generally consistent to our cost of products revenueincurred in the third quarter of fiscal year 2004.

 

33

----

 

*Costof SCOsource Licensing Revenue* 

 
| ** **                                | ** ** | **Three Months Ended July 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                                      |       |                            |       |   |   |   |   |
| Cost of SCOsource licensing revenue       |       | $                               | 7,396,000  |   | 312 | % | $ | 1,796,000 |   |
| Percentage of SCOsource licensing revenue |       | 1091                            | %          |   |   | 25 | % |
|                                      |       |                            |       |   |   |   |   |
| ** **                                | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                                | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                                      |       |                            |       |   |   |   |   |
| Cost of SCOsource licensing revenue       |       | $                               | 15,486,000 |   | 275 | % | $ | 4,129,000 |   |
| Percentage of SCOsource licensing revenue |       | 2184                            | %          |   |   | 27 | % |

 

Costof SCOsource licensing revenue includes the salaries and related personnelcosts of employees dedicated to the SCOsource licensing initiatives, legal andprofessional fees incurred in connection with our SCOsource initiatives, and anallocation of corporate costs.

 

Cost ofSCOsource licensing revenue increased significantly in the third quarter andfirst three quarters of fiscal year 2004 compared to the third quarter andfirst three quarters of fiscal year 2003. The increased costs in the 2004 periods compared to the 2003 periods wasprimarily attributable to increased legal fees incurred in connection with ourongoing litigation with IBM, Novell, AutoZone and DaimlerChrysler as well asour continued pursuit of intellectual property licenses.  We expect that legal fees will vary from quarterto quarter depending on the level of, and activity surrounding, ourintellectual property claims, and therefore are difficult to predict.  Additionally, the cost of SCOsource licensingrevenue likely will fluctuate from quarter to quarter due in part to theunpredictability of the related SCOsource revenue.  Although we currently intend to cap ourpotential legal expenses by revising our fee agreement with BSF, as describedbelow, legal expenses could increase over time depending on developments in ourongoing litigation.  Legal expenses mayalso include contingency payments made to BSF and the other law firms engagedby us to protect our intellectual property rights, which at this time we areunable to predict the amount or timing of such contingency fees.  Additionally, we are unable to predict thepercentage of cost of SCOsource licensing revenue for future quarters due tothe unpredictability of the related licensing revenue.

 

On August 31, 2004, we announced wehad entered into anonbinding letter of intent with BSF, to revise the existing fee agreement withBSF to limit our overall future cash costs of legal fees, including accruedlegal fees as of July 31, 2004, associated with our pending intellectualproperty litigation to a total of $31,000,000.  In addition, thenonbinding letter of intent contemplates that BSF will lead our intellectualproperty legal efforts through the duration and completion of the pendinglitigation.  In return for the new feearrangement, the letter of intent provides that the contingency fee payable toBSF and other law firms associated with any settlement or judgment award willvary on a scaled basis from 20 to 33 percent, depending on the size of theaward.  The revised fee agreement issubject to the Company and BSF entering into a definitive revised feeagreement.  These developments, ifcompleted, will allow us to better predict future cost of SCOsource licensingrevenue.

 

*Cost of Services Revenue*

 
| ** **                     | ** ** | **Three Months Ended July 31,** | ** ** |
|--------------------------------|------------|---------------------------------|------------|
| ** **                     | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                           |       |                            |       |   |   |   |   |
| Cost of services revenue       |       | $                               | 878,000    |   | (43 | )% | $ | 1,538,000 |   |
| Percentage of services revenue |       | 55                              | %          |   |   | 78 | % |
|                           |       |                            |       |   |   |   |   |
| ** **                     | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                     | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                           |       |                            |       |   |   |   |   |
| Cost of services revenue       |       | $                               | 3,273,000  |   | (35 | )% | $ | 5,008,000 |   |
| Percentage of services revenue |       | 66                              | %          |   |   | 78 | % |

 

34

----

 

Cost ofservices revenue includes the salaries and related personnel costs of employeesdelivering services revenue as well as third-party service agreements.  Cost of services revenue decreased by$660,000, or 43 percent, for the third quarter of fiscal year 2004 compared tothe third quarter of fiscal year 2003 and decreased by $1,735,000, or 35percent, for the first three quarters of fiscal year 2004 compared to the firstthree quarters of fiscal year 2003.  Thisdecrease was attributable in part to lower services revenue, reduced employeeand related costs in our support services and professional services groups aswell as the elimination of certain third-party support contracts in order toincrease the gross margin for these groups.

 

Forthe fourth quarter of fiscal year 2004, we expect the dollar amount of our costof services revenue to be lower than our cost of services revenue incurred inthe third quarter of fiscal year 2004.

 

*Sales and Marketing*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Sales and marketing expense |       | $                               | 4,233,000  |   | (29 | )% | $ | 5,930,000 |   |
| Percentage of total revenue |       | 38                              | %          |   |   | 30 | % |
|                        |       |                            |       |   |   |   |   |
| ** **                  | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Sales and marketing expense |       | $                               | 13,952,000 |   | (24 | )% | $ | 18,421,000 |   |
| Percentage of total revenue |       | 43                              | %          |   |   | 34 | % |

 

Sales andmarketing expenses consist of the salaries, commissions and other personnelcosts of employees involved in the revenue generation process, as well asadvertising and corporate allocations. The decrease in sales and marketing expenses from the third quarter offiscal year 2003 to the third quarter of fiscal year 2004 of $1,697,000, or 29percent, and the decrease in sales and marketing expense from the first threequarters of fiscal year 2003 to the first three quarters of fiscal year 2004 of$4,469,000, or 24 percent, was primarily attributable to reductions in salesand marketing employees, reduced travel expenses, and lower commissions.  Our sales and marketing expenses as apercentage of total revenue were higher in the fiscal year 2004 periodscompared to the fiscal year 2003 periods primarily as a result of lower totalrevenue in the 2004 periods.  Our salesand marketing headcount decreased from 124 as of July 31, 2003, to 72 as ofJuly 31, 2004.

 

Forthe fourth quarter of fiscal year 2004, we anticipate the dollar amount ofsales and marketing expenses will decrease compared to the third quarter offiscal year 2004.

 

*Research and Development*

 
| ** **                       | ** ** | **Three Months Ended July 31,** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                             |       |                            |       |   |   |   |   |
| Research and development expense |       | $                               | 2,592,000  |   | (12 | )% | $ | 2,950,000 |   |
| Percentage of total revenue      |       | 23                              | %          |   |   | 15 | % |
|                             |       |                            |       |   |   |   |   |
| ** **                       | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                       | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                             |       |                            |       |   |   |   |   |
| Research and development expense |       | $                               | 8,167,000  |   | 0 | % | $ | 8,142,000 |   |
| Percentage of total revenue      |       | 25                              | %          |   |   | 15 | % |

 

35

----

 

Researchand development expenses consist of the salaries and benefits of softwareengineers, consulting expenses as well as corporate allocations.  The decrease in research and developmentexpense in the third quarter of fiscal year 2004 of $358,000, or 12 percent,compared to the third quarter of fiscal year 2003 was primarily attributable toreductions in research and development employees and related employeecosts.  Research and development expensesfor the first three quarters of fiscal year 2004 compared to the first threequarters of fiscal year 2003 were flat. Our research and development expenses as a percentage of total revenuewere higher in the fiscal year 2004 periods compared to the fiscal year 2003periods primarily as a result of lower total revenue in the 2004 periods.  Our research and development personneldecreased from 84 as of July 31, 2003, to 75 as of July 31, 2004.

 

Forthe fourth quarter of fiscal year 2004, we anticipate the dollar amount ofresearch and development expenses will decrease compared to the third quarterof fiscal year 2004 due to recently implemented cost reductions.

 

*General and Administrative*

 
| ** **                         | ** ** | **Three Months Ended July 31,** | ** ** |
|------------------------------------|------------|---------------------------------|------------|
| ** **                         | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                               |       |                            |       |   |   |   |   |
| General and administrative expense |       | $                               | 1,889,000  |   | 34 | % | $ | 1,413,000 |   |
| Percentage of total revenue        |       | 17                              | %          |   |   | 7 | % |
|                               |       |                            |       |   |   |   |   |
| ** **                         | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                         | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                               |       |                            |       |   |   |   |   |
| General and administrative expense |       | $                               | 6,475,000  |   | 43 | % | $ | 4,525,000 |   |
| Percentage of total revenue        |       | 20                              | %          |   |   | 8 | % |

 

Generaland administrative expenses consist of the salaries and benefits of finance,human resources and executive management and expenses for external professionalservices as well as corporate allocations. Included in general and administrative expense for the first threequarters of fiscal year 2004 are $682,000 in payments made in connection withthe elimination of approximately 16 percent of our workforce which occurredduring the second quarter of fiscal year 2004.

 

Theincrease in general and administrative expense from the third quarter and firstthree quarters of fiscal year 2003 of $476,000 and $1,950,000, respectively,compared to the third quarter and first three quarters of fiscal year 2004,exclusive of the above mentioned termination payments, was attributable toincreased legal costs as a result of corporate and regulatory legal matters andincreased fees from other non-legal professional service providers, even thoughour general and administrative headcount decreased from 52 as of July 31, 2003to 41 as of July 31, 2004.  Our generaland administrative expenses as a percentage of total revenue were higher in thefiscal year 2004 periods compared to the fiscal year 2003 periods in part dueto lower total revenue in the 2004 periods.

 

Forthe fourth quarter of fiscal year 2004, we anticipate the dollar amount ofgeneral and administrative expenses will be consistent with the third quarterof fiscal year 2004.

 

36

----

 

*Restructuring Charges*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Restructuring charges       |       | $                               | —     |   | n/a |   | $ | 614,000 |   |
| Percentage of total revenue |       | 0                               | %          |   |   | 3 | % |
|                        |       |                            |       |   |   |   |   |
| ** **                  | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Restructuring charges       |       | $                               | —     |   | n/a |   | $ | 498,000 |   |
| Percentage of total revenue |       | 0                               | %          |   |   | 1 | % |

 

We did notincur any restructuring charges during the third quarter or first threequarters of fiscal year 2004.  During thethird quarter of fiscal year 2003, the Company incurred a restructuring chargeof $614,000 in connection with the termination of employment for certainpositions.  The restructuring charge of$498,000 for the first three quarters of fiscal year 2003 was comprised of theaction described above for the third quarter of fiscal year 2003, the closingof the Company’s UK subsidiary, offset by adjustments to previously recordedaccruals.

 

Duringthe fourth quarter of fiscal year 2004, we plan to take additional costreduction actions, which will include reductions in staff as well as certainreductions and consolidation in office space, which will further decrease ouroperating costs.  We estimate that therestructure costs associated with these actions may be approximately$2,000,000, but the actual costs associated with these actions may differ fromthis estimate.

 

*Amortization of Intangibles*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Amortization of intangibles |       | $                               | 593,000    |   | (34 | )% | $ | 895,000 |   |
| Percentage of total revenue |       | 5                               | %          |   |   | 4 | % |
|                        |       |                            |       |   |   |   |   |
| ** **                  | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Amortization of intangibles |       | $                               | 1,973,000  |   | (14 | )% | $ | 2,295,000 |   |
| Percentage of total revenue |       | 6                               | %          |   |   | 4 | % |

 

Amortization of intangibles is the expensingof previously recorded amounts for assets recorded in prior acquisitions withfinite lives.  The decrease inamortization of intangibles of $302,000 for the third quarter of fiscal year2004 compared to the third quarter of fiscal year 2003 and the decrease of$322,000 for the first three quarters of fiscal year 2004 compared to the firstthree quarters of fiscal year 2003 was primarily attributable to reducedamortization expense recorded on certain assets and technology acquired fromThe Santa Cruz Operation (now Tarantella, Inc.).

 

*Loss on Impairment of Long-lived Assets*

 

We did nothave any impairment charges during the third quarter of fiscal year 2004.  However, we recorded a loss on impairment oflong-lived assets totaling $2,139,000 for the first three quarters of fiscalyear 2004.  The impairment related togoodwill and intangible assets acquired in connection with our acquisition ofVultus in June 2003.  We concluded thatan impairment triggering event occurred as an impending partnership that wouldsolidify the Vultus revenue and cash flow opportunities did notmaterialize.  Consequently, we haveconcluded that no significant future cash flows related to our Vultus assetswill be realized.  We

 

37

----

 

performed an impairmentanalysis of our recorded goodwill related to the Vultus reporting unit in accordancewith SFAS No. 142.  Additionally, animpairment analysis of the intangible assets was performed in accordance withSFAS No. 144.  As a result of theseanalyses, we wrote-down the carrying value of our goodwill related to ourVultus acquisition from $1,166,000 to $0, and wrote-down the intangible assetsrelated to our Vultus acquisition from $973,000 to $0.  We did not incur any impairment charges inthe third quarter or first three quarters of fiscal year 2003.

 

*Stock-based Compensation*

 
| ** **                  | ** ** | **Three Months Ended July 31,** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Stock-based compensation    |       | $                               | 270,000    |   | (13 | )% | $ | 309,000 |   |
| Percentage of total revenue |       | 2                               | %          |   |   | 2 | % |
|                        |       |                            |       |   |   |   |   |
| ** **                  | ** ** | **Nine Months Ended July 31,**  | ** ** |
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Stock-based compensation    |       | $                               | 868,000    |   | (6 | )% | $ | 927,000 |   |
| Percentage of total revenue |       | 3                               | %          |   |   | 2 | % |

 

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

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

 

*Equity inIncome (Losses) of Affiliates*

 

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

 

*OtherIncome (Expense), net*

 

Other income(expense) consisted of the following components for the three and nine monthsended July 31, 2004 and 2003 (in thousands):

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

 

38

----

 

Interestincome increased by $144,000 for the third quarter of fiscal year 2004 comparedto the third quarter of fiscal year 2003 and increased by $606,000 for thefirst three quarters of fiscal year 2004 compared to the first three quartersof fiscal year 2003 as a result of interest earned on higher cashbalances.  The income recorded for thefirst three quarters of fiscal year 2004 of $5,924,000 on the change in fairvalue of the derivative related to thedecreasing fair value of this instrument and marking it to market at eachbalance sheet date.  Thederivative financial instrument was eliminated during the second quarter offiscal year 2004.

 

*Provision for Income Taxes*

 

The provision for income taxes was $176,000 in the third quarter offiscal year 2004 and $188,000 in the third quarter of fiscal year 2003 and$1,270,000 for the first three quarters of fiscal year 2004 and $495,000 forthe first three quarters of fiscal year 2003. The increase in the provisionfor income taxes for the first three quarters of fiscal year 2004 compared tothe first three quarters of fiscal year 2003 was primarily attributable toaccruals for withholding taxes that are estimated to be paid in connection withthe operations of the Indian branch of our United Kingdom subsidiary, The SCOGroup, Ltd.

 

*DividendsRelated to Redeemable Convertible Preferred Stock*

 

In connectionwith completing the February 5, 2004 exchange of Series A-1 shares for Series Ashares, 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 first three quarters of fiscal year 2004.

 

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

 

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

 

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

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

 

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**Liquidityand Capital Resources**

 

Our cash andequivalents and available-for-sale securities balances decreased from$68,523,000 as of October 31, 2003 to $43,027,000 as of July 31, 2004 and ourworking capital decreased from $37,168,000 as of October 31, 2003 to$20,374,000 as of July 31, 2004.  Our cashand equivalents decreased from $64,428,000 as of October 31, 2003 to$15,982,000 as of July 31, 2004, primarily as a result of purchases ofavailable-for-sale securities, cash denoted as restricted cash to fund theBayStar stock repurchase and from cash used in operations.

 

During fiscalyear 2003, we completed a private placement of 50,000 Series A shares for netproceeds of $47,740,000 in October 2003, which shares were exchanged for SeriesA-1 shares in February 2004 and which in turn we repurchased from BayStar inJuly 2004.  Because we repurchased theoutstanding Series A-1 shares, the net proceeds received in our privateplacement are reduced by the $13,000,000 cash component of the repurchaseprice.  We intend to use the net proceedsfrom our preferred stock financing as well as our other cash resources topursue our SCOsource initiatives and fund other cash needs of ourbusiness.  During the first threequarters of fiscal year 2004, we used $10,703,000 of cash in our operations.  We believe that we will have sufficient cashresources to fund our current operations for at least the next 12 months.

 

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

 

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

 

Ourinvesting activities have historically consisted of equipment purchases,investing in strategic partners and the purchase and sale of available-for-salesecurities.  During the first threequarters of fiscal year 2004, cash used in investing activities was$23,650,000, which was primarily a result of our purchase of available-for-salesecurities (net of sales) of $23,110,000, equipment purchases of $331,000 andcash used to acquire the outstanding minority interest in our Japanesesubsidiary of $209,000.  Cash used ininvesting activities was $1,474,000 for the first three quarters of fiscal year2003 and was attributable to equipment purchases of $524,000 and an investmentin non-marketable securities of $950,000.

 

Our financing activities used $14,224,000during the first three quarters of fiscal year 2004 and consisted primarily of$13,000,000 in cash reserved to fund the repurchase of Series A-1

 

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shares from BayStar, cash usedto purchase shares of our common stock on the open market of $2,414,000 andcash used in the exchange of Series A-1 for Series A shares of $211,000.  These uses of cash were offset from proceedsreceived from the exercise of stock options of $591,000 and proceeds from thepurchase of shares of common stock by our employees through our employee stockpurchase program of $810,000.  Cashprovided by financing activities was $2,329,000 for the first three quarters offiscal year 2003 and was attributable to proceeds received from the exercise ofstock options of $1,443,000, the exercise of a warrant for $650,000 andproceeds from the purchase of shares of common stock by our employees throughour employee stock purchase program of $236,000.

 

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

 

As explained above in this Item 2 under the caption“Recent Developments,” we have entered into a nonbinding letter of intent with BSF, our outside litigation legalcounsel, to revise the existing fee agreement with BSF.  Upon completing the revised agreement, weexpect we will limit our future cash costs of legal fees, including accruedlegal fees to BSF as of July 31, 2004, associated with our pending intellectualproperty litigation to a total of $31,000,000.  In addition, thenonbinding letter of intent provides that the contingency fee payable to BSFand other law firms associated with any settlement or judgment award, which iscurrently set at 20 percent, will vary on a scaled basis from 20 to 33 percent,depending on the size of the award.  Eventsthat may trigger a contingency fee may include settlements, judgments, certainlicensing fees, subject to certain exceptions, and a sale of our company duringthe pendancy of litigation or through settlement, subject to agreed uponcredits for amounts received as discounted hourly fees and unused retainerfees.  Additionally, our currentagreement with the law firms may also be construed to include contingency feepayments in connection with our issuance of equity securities, although wecurrently anticipate eliminating this contingency in the contemplated revisedfee agreement.

 

We expect that legal fees will vary from quarter toquarter depending on the level of, and activity surrounding, our intellectualproperty claims, and therefore such costs are difficult to predict.  Additionally, although weintend to cap our potential legal expenses by revising our fee agreement withBSF, legal expenses could increase over time depending on developmentsin litigation involving us, and certain events outside of our control couldoccur or certain contingent events could take place that would require us topay additional fees to the law firms.  Tothe extent that our SCOsource related costs and legal fees exceed our budgetedamounts, or SCOsource revenue is below our expectations, our liquidity will beadversely impacted and fewer financial resources will be available for otherinitiatives such as maintaining and enhancing our UNIX business.  Additionally, future contingency fees payableto the law firms may be significant in future periods, which may have anadverse impact on our liquidity.  Ourcurrent fee arrangement with our law firms could also impair our ability toraise equity capital in future periods. If we are not able to enter into a definitive revised fee agreement withBSF that effectively limits the cash payments we may be required to make topursue our claims, our liquidity will be adversely impacted.

 

We have entered into operating leases for ourcorporate offices located in the United States and our international salesoffices.  We have commitments under theseleases that extend through fiscal year 2010. In prior corporate restructuring actions,  we partially vacated some of thesefacilities, but still have contractual obligations to continue to make ongoinglease payments

 

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for one facility that will useavailable cash.  We have pursued and willcontinue to pursue sublease opportunities, as available, to minimize this useof cash; however, we may not be successful in eliminating or reducing cashexpenditures for this facility.

 

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

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

 

As of July 31, 2004, we did not have any long-termdebt obligations, purchase obligations or material capital lease obligations.

 

During fiscal year 2004, we have undertaken certaincost-cutting measures to reduce our overall operating costs.  These cost-cutting measures have focused onstreamlining operations and job functions where possible, and have impacted alloperating departments within the Company. Even though we have undertaken these measures, our ability in the futureto cut costs to offset revenue declines in our UNIX business is limited to acertain extent because of contractual commitments to maintain and support ourexisting UNIX customers.  The decline in our UNIX business maybe accelerated if industry partners withdraw their support as a result ofdeclines in our UNIX business or our SCOsource initiatives and in particularany lawsuits against end users violating our intellectual property andcontractual rights.  The decline in ourUNIX business and our SCOsource initiatives, particularly lawsuits against suchend users, may cause industry partners, developers and hardware and softwarevendors to choose not to support or certify to our UNIX operating systemproducts.  This may lead to anaccelerated decline in our UNIX products and services revenue.  If our UNIX products and servicesrevenue is less than expected, our liquidity will be adversely impacted.

 

Inthe event that cash required to fund operations and strategic initiativesexceeds our current cash resources and cash generated from operations, we willbe required to reduce costs and perhaps raise additional capital.  We may not be able to reduce costs in amanner that does not impair our ability to maintain our UNIX business andpursue our SCOsource initiatives.  We mayalso not be able to raise capital for any number of reasons including thoselisted under the section “Risk Factors” below. If additional equity financing is available, it may not be available tous on attractive 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.

 

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

 

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**Recent Accounting Pronouncements**

 

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

 

**ITEM3****.****                                                 ****QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

*ForeignCurrency 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.  Most of this international revenue isdenominated in U.S. dollars.  However,most of the operating expenses related to our foreign-based operations aredenominated in foreign currencies and therefore operating results are affectedby changes in the U.S. dollar exchange rate in relation to foreign currenciessuch as the Euro, among others.  If theU.S. dollar weakens compared to the Euro, our operating expenses for foreignoperations will be higher when translated back into U.S. dollars.  Our revenue can also be affected by generaleconomic conditions in the United States, Europe and other internationalmarkets.  Our results of operations maybe affected in the short term by fluctuations in foreign currency exchangerates.

 

We have in the pastutilized foreign currency forward exchange contracts for market exposures of underlyingassets and liabilities.  We do not useforward 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 the contracts’ effectiveness in risk reduction and one-to-onematching of forward exchange contracts to underlying assets andliabilities.  Gains and losses oncurrency forward contracts that are firm commitments are deferred and recognizedin income in the same period that the underlying transactions are settled.  Gains and losses on currency forwardcontracts that are designated and effective for existing transactions arerecognized in income in the same period as losses and gains on the underlyingtransactions are recognized and generally offset.  Gains and losses on any instruments notmeeting the above criteria are recognized in income in the current period.  As of July 31, 2004, we had no outstandinginstruments classified as hedges.

 

*Interest Rate Risk. *The primary objective of our cash management strategy is to investavailable funds in a manner that assures maximum safety and liquidity andmaximizes yield within such constraints. We do not borrow money for short-term investment purposes.

 

*Investment Risk. *We have invested in equity instruments of privately held and publiccompanies in the 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 to exerciseinfluence over operations.  Ourinvestment policy is to regularly review the assumptions and operatingperformance of these companies and to record impairment losses when events andcircumstances indicate that these investments may be impaired.  As of July 31, 2004,

 

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our investments balance wasapproximately $565,000 and was related to our investment in a 30 percent ownedChinese company.

 

The stock market in general, and the market forshares of technology companies in particular, has experienced extreme pricefluctuations.  In addition, factors suchas new product introductions by our competitors or developments in the litigationrelated to our SCOsource initiatives may have a significant impact on themarket price of our common stock. Furthermore, quarter-to-quarter fluctuations in our results ofoperations caused by changes in customer demand may have a significant impacton the market price of our common stock. These conditions could cause the price of our common stock to fluctuatesubstantially over short periods of time.

 

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

 

*Evaluation of disclosure controls and 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) and 15d-15(e) under the Securities Exchange Act of 1934 (the“Exchange Act”)).  Based upon thatevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat, as of the end of the period covered by this report, our disclosurecontrols and procedures were adequately designed to ensure that informationrequired to be disclosed by us in the reports we file or submit under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in applicable rules and forms.

 

*Changes in internal control over financialreporting.*  During themost recent fiscal quarter ended July 31, 2004, there has been no change in ourinternal control over financial reporting (as defined in Rule 13a-15(f) and15d-15(f) under the Exchange Act) that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

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

 

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

 

•                              Ourcontinued investment in and commitment to our UNIX operating systems, includinginvesting in research and development efforts during fiscal year 2004 toenhance our OpenServer and UnixWare, which enhancements we believe will helpprolong our UNIX revenue stream for future quarters;

 

•                              Ourestimation that the decline in our UNIX business revenue may be accelerated ifindustry partners withdraw their support as a result of our declining UNIXbusiness and our SCOsource initiatives and in particular any lawsuits againstend users violating our intellectual property and contractual rights;

 

•                              Ourbelief that the future success of our SCOsource initiatives will depend on ourability to protect our intellectual property;

 

•                              Ourexpectation that quarterly legal fees and other SCOsource related costs willvary from quarter to quarter depending upon the level of, and activitysurrounding, our intellectual property claims, and therefore are difficult topredict;

 

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•                              Ouranticipation that we will enter into a revised fee agreement with BSF ascontemplated in our nonbinding letter of intent that will limit the future cashcosts of legal fees, including accrued legal fees to BSF as of July 31, 2004,associated with our pending intellectual property litigation to a total of$31,000,000, confirm that BSF will lead our intellectual property legal effortsthrough the duration and completion of our pending litigation, provide that thecontingency fee payable to BSF and other law firms associated with anysettlement or judgment award will vary on a scaled basis from 20 to 33 percent,depending upon the size of the award, and eliminate the right of our law firmsto receive any contingency fee payment in connection with any issuance ofequity securities;

 

•                              Ourexpectation that, although we intend to cap our potential legal expenses byrevising our fee agreement with BSF, our legal expenses could increasedepending on developments in our litigation, and, even if we do revise our feeagreement with BSF, the occurrence of certain events outside our control orcertain contingent events could require us to pay additional fees to our lawfirms;

 

•                              Ourintention to continue seeking to enter into license agreements with UNIXvendors and offering SCOsource IP licenses to Linux end users;

 

•                              Ouranticipation that for the fourth quarter of fiscal year 2004 our UNIX revenuewill be consistent with or slightly lower than revenue generated in the thirdquarter of fiscal year 2004;

 

•                              Ourexpectation that our UNIX business will continue to be impacted by competitionfrom Linux;

 

•                              Ourexpectation that during the fourth quarter of fiscal year 2004, we will takeadditional cost reduction actions, which will include reductions in staff aswell as certain reductions and consolidation in office space, which willfurther decrease the operating costs of our UNIX business.  We estimate that the restructure costassociated with these actions may be approximately $2,000,000, but the actualcost associated with these actions may differ from this estimate;

 

•                              Ourexpectation that our future level of services revenue depends in part on ourability to generate UNIX products revenue from existing customers as well asrenew certain annual support and services agreements with existing UNIXcustomers;

 

•                              Ourexpectation for the fourth quarter of fiscal year 2004 that our cost ofproducts revenue in dollars will be consistent with our cost of productsrevenue incurred in the third quarter of fiscal year 2004;

 

•                              Ourexpectation for the fourth quarter of fiscal year 2004 that our cost ofservices revenue in dollars will be lower than in the third quarter of fiscalyear 2004;

 

•                              Ourexpectation for the fourth quarter of fiscal year 2004 that our sales andmarketing expenses in dollars will decrease from our expenses incurred in thethird quarter of fiscal year 2004;

 

•                              Ourexpectation for the fourth quarter of fiscal year 2004 that our research anddevelopment expenses in dollars will decrease from our expenses incurred in thethird quarter of fiscal year 2004 due to recently implemented cost reductions;

 

•                              Ourexpectation for the fourth quarter of fiscal year 2004 that our general andadministrative expenses in dollars will be consistent with our general andadministrative expenses incurred in the third quarter of fiscal year 2004;

 

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•                              Ourbelief that the India Income Tax Department probably will pursue taxassessments on revenue for taxable periods subsequent to March 2001 deemed bysuch tax authority to be royalty revenue of our UK subsidiary, The SCO Group,Ltd.;

 

•                              Ourintention to use the net proceeds from our preferred stock financing as well asour other cash resources to pursue our SCOsource initiatives and fund othercash needs of our business;

 

•                              Ourbelief that we have sufficient cash resources to fund our current operationsfor at least the next 12 months;

 

•                              Ourbelief that our allowance for bad debts will remain consistent with our priorexperience; and

 

•                              Ourbelief that certain legal actions to which we are a party will not have amaterial adverse effect on us.

 

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

 

**Risk Factors**

 

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

 

Our fiscal year ended October 31, 2003 was the firstfull year we were profitable in our operating history.  Our profitability in fiscal year 2003resulted primarily from our SCOsource licensing initiatives.  For the nine months ended July 31, 2004, weincurred a net loss from operations of $21,963,000 and our accumulated deficitas of July 31, 2004 was $217,700,000.  Ifwe do not receive SCOsource licensing revenue in future quarters and ourrevenue from the sale of our UNIX products and services continues to decline,we will need to further reduce operating expenses to generate positive cashflow.  We may not be able to furtherreduce operating expenses without damaging our ability to support our existingUNIX business.  Additionally, we may notbe able to achieve profitability through additional cost-cutting actions.

 

Our UNIX products and services revenue has declined ineach of the last four years primarily as a result of increasedcompetition from alternative operating systems, particularly Linux, lowerinformation technology spending for UNIX products, and a general overalldecline in economic conditions. In our quarterly results of operations, we recognize revenue fromagreements for support and maintenance contracts and other long-term contractsthat have been previously invoiced and are included in deferred revenue.  While our deferred revenue balance increasedfrom $5,501,000 as of October 31, 2003 to $5,936,000 as of July 31, 2004, ourdeferred revenue balance had declined prior to this period and this recentmodest increase in deferred revenue may not continue into future quarters,which may have a negative impact on our UNIX revenue.  Our future UNIX revenue may be adverselyimpacted and may continue to decline if we are unable to replenish thesedeferred revenue balances with long-term maintenance and

 

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support contracts or replacethem with other sustainable revenue streams. If we are unable to generate positive cash flow and profitableoperations, our operations may be adversely impacted.

 

*Our future SCOsource licensing revenue is uncertain.*

 

We initiated the SCOsource licensing effort in January2003 to review the status of UNIX licensing and sublicensing agreements.  This effort resulted in the execution of twosignificant vendor license agreements during fiscal year 2003 and generated$25,846,000 in revenue.  During the threeand nine months ended July 31, 2004, we recorded SCOsource licensing revenue of$678,000 and $709,000, respectively, related to the execution of intellectualproperty compliance licenses.  Due to alack of historical experience and the uncertainties related to SCOsourcelicensing revenue, we are unable to estimate the amount and timing of futureSCOsource licensing revenue, if any.  Ifwe do receive revenue from this source, it may be sporadic and fluctuate fromquarter to quarter.  Our SCOsourceinitiatives are unlikely to produce stable, predictable revenue for theforeseeable future.  Additionally, thesuccess of these initiatives may depend on the strength of our intellectualproperty rights and contractual claims regarding UNIX, including the strengthof our claim that unauthorized UNIX source code and derivatives are prevalentin Linux.

 

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

 

We continue to pursue our litigation againstIBM.  As described in more detail in Item1 of Part II of this quarterly report, we seek damages for claims generallyrelating to our allegation that IBM has inappropriately used and distributedour UNIX source code and derivative works in connection with its efforts topromote the Linux operating system.  IBMhas responded to our claims and brought counterclaims against us assertinggenerally that we do not have the right to assert claims based on our ownershipof UNIX intellectual property against IBM or others in the Linuxcommunity.  Discovery is continuing inthe case, and several motions are currently pending before the court.  If we do not prevail in our action againstIBM, or if IBM is successful in its counterclaims against us, our business andresults of operations could be materially harmed and we may not be able to continuein business. The litigation with IBM and others will be costly, and our costsfor legal fees have been and may continue to be substantial and may exceed ourcapital resources. Additionally, the market price of our common stock may benegatively affected as a result of developments in our legal action against IBMthat may be, or may be perceived to be, adverse to us.

 

In addition, we have publicly, and inindividual letters, cautioned users of Linux that there are unresolvedintellectual property issues surrounding Linux that may expose them tounanticipated liability to us.  We havealso notified a large number of licensees under our UNIX contracts requiringthem to, among other things, certify they are in compliance with theiragreements, including that they are not using our proprietary UNIX code inLinux, have not allowed unauthorized use of licensed UNIX code by theiremployees or contractors and have not breached confidentiality provisionsrelating to licensed UNIX code.    As a result of our action against IBM and our other SCOsource initiativesto protect our intellectual property rights, several participants in the Linuxindustry and others affiliated with IBM or sympathetic to the Linux movementhave taken actions attempting to negatively affect our business and ourSCOsource efforts. Linux proponents have taken a broad range of actions againstus, including, for example, attempting to influence participants in the marketsin which we sell our products to reduce or eliminate the amount of our productsand services they purchase from us. We expect that similar efforts likely willcontinue. There is a risk that participants in our marketplace will negativelyview our action against IBM, DaimlerChrysler and AutoZone and our otherSCOsource initiatives, and we may lose support from such participants.  Any of the foregoing could adversely affectour position in the marketplace, our results of operations and our stock priceand our ability to stay in business.   Wehave also

 

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experienced severaldenial-of-service attacks on our website, which have prevented web users fromaccessing our website and doing business with us for a period of time. If suchattacks continue or if our customers and strategic partners are also subjectedto similar attacks, our business and results of operations could be materiallyharmed.

 

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

 

As a further response to our SCOsourceinitiatives and claim that our UNIX source code and derivative works haveinappropriately been included in Linux, Novell has publicly asserted its beliefthat it owns certain copyrights in our UNIX source code, and it has filed 15copyright applications with the United States Copyright Office related toUNIX.  Novell also claims that it has alicense 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 haverepeatedly asserted that we obtained the UNIX business, source code, claims andcopyrights when we acquired the assets and operations of the server andprofessional services groups from The Santa Cruz Operation (now Tarantella,Inc.) in May 2001, which had previously acquired all such assets andrights from Novell in September 1995 pursuant to an asset purchase agreement,as amended.  In January 2004, in responseto Novell’s actions, we brought suit against Novell for slander of titleseeking relief for Novell’s alleged bad faith effort to interfere with ourcopyrights related to our UNIX source code and derivative works and ourUnixWare products.  Our lawsuit againstNovell is also described in more detail in Item 1 of Part II of this quarterlyreport.

 

Notwithstanding our assertions of fullownership of UNIX-related intellectual property rights, as set forth above,including copyrights, and even if we are successful in our legal action againstNovell and end users such as AutoZone and DaimlerChrysler, the efforts ofNovell and the other Linux proponents described above may cause Linux end usersto be less willing to purchase from us our SCOsource IP licenses authorizingtheir use of our intellectual property contained in the Linux operating system,which may adversely affect our revenue from our SCOsource initiatives.  These efforts of Linux proponents also mayincrease the negative view some participants in our marketplace have regardingour legal actions against IBM, Novell and end users such as AutoZone andDaimlerChrysler and regarding our SCOsource initiatives and may contribute tocreating confusion in the marketplace about the validity of our claim that theunauthorized use of our UNIX source code and derivative works in Linuxinfringes on our copyrights.  Increasednegative perception and potential confusion about our claims in our marketplacecould impede our continued pursuit of our SCOsource initiatives and negativelyimpact our business. Additionally, if we fail in our lawsuit against Novell andend users such as AutoZone and DaimlerChrysler, the negative perception andconfusion in our marketplace about our intellectual property rights and claimslikely would increase significantly, and the effectiveness of our SCOsourceinitiatives could be materially harmed.

 

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

 

The decline in our UNIX business and ourSCOsource initiatives, particularly lawsuits against end users violating ourintellectual property and contractual rights, may cause industry partners,developers and hardware and software vendors to choose not to support orcertify to our UNIX operating system products. This would lead to an accelerated decline in our UNIX products andservices revenue and would adversely impact our results of operations andliquidity.

 

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

 

In August 2003, Red Hat brought alawsuit against us asserting that the Linux operating system does not infringeon our UNIX intellectual property rights and seeks a declaratory judgment fornon-infringement of copyrights and no misappropriation of trade secrets.  In addition, Red Hat claims we have engagedin false advertising in violation of the Lanham Act, deceptive trade practices,unfair competition, tortious interference with prospective businessopportunities, and trade libel and disparagement.  We intend to vigorously defend this action,but if Red Hat is successful in its claim against us, our business and resultsof operations could be materially harmed.

 

In addition, other regulators or others inthe Linux community have initiated or in the future may initiate legal actionsagainst us, all of which may negatively impact our operations or futureoperating performance.

 

*Fluctuations in ouroperating 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 quarterly operatingresults or our failure to meet the expectations of analysts or investors, evenin the short-term, could cause our stock price to decline significantly.Because of the potential for significant fluctuations in our SCOsourcelicensing revenue in any particular period, you should not rely on quarter-to-quartercomparisons of our results of operations as an indication of futureperformance.

 

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 recommendingour UNIX 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 and recruiting efforts inthe software industry;

 

•                                          results of, or developments in, our ongoinglitigation with IBM, Novell, Red Hat, AutoZone and DaimlerChrysler concerningour UNIX intellectual property;

 

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

 

•                                          the contingency and other legal fees we may pay tothe law firms representing us in our efforts to establish our intellectualproperty rights; and

 

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•                                          changes in attitudes of customers and partners dueto the decline in our UNIX business and our aggressive position against theinclusion of our UNIX code and derivative works in Linux and our lawsuitsagainst end users violating our intellectual property and contractual rights.

 

We also experience fluctuations in operatingresults in interim periods in Europe and the Asia Pacific regions due toseasonal slowdowns 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 inresponse to these events.

 

*We rely on ourindirect sales channel for distribution of our products, and any disruption ofour channel at any level could adversely affect the sales of our products.*

 

We have a two-tiered distribution channel.The relationships we have developed with resellers allow us to offer ourproducts and services to a much larger customer base than we would otherwise beable to reach through our own direct sales and marketing efforts. Some solutionproviders also purchase solutions through our resellers, and we anticipate theywill continue to do so. Because we usually sell indirectly through resellers,we cannot control the relationships through which resellers, solution providersor equipment integrators purchase our products. In turn, we do not control the presentation of our products to endusers. 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 andsolution providers may choose not to emphasize our products to their customers.Any of these occurrences could diminish the effectiveness of our distributionchannel and lead to decreased sales.

 

*If the market forUNIX continues to contract, our business will be harmed.*

 

Our revenue from the sale of UNIX productshas declined over the last four years. This decrease in revenue has beenattributable primarily to increased competition from other operating systems,particularly Linux and lower information technology spending for UNIX products.Our sales of UNIX products and services are primarily to existingcustomers.  If the demand for UNIX productscontinues to decline, and we are unable to develop UNIX products and servicesthat successfully address a market demand, our UNIX revenue will continue todecline, industry participants may not certify to our operating system andproducts, we may not be able to attract new customers or retain existingcustomers and our business and results of operations will be adverselyaffected.  Because of the long adoptioncycle for operating system purchases and the long sales cycle of our operatingsystem products, we may not be able to reverse these revenue declines quickly.

 

*We operate in ahighly 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.*

 

In the UNIX operating system market, ourcompetitors include IBM, Hewlett-Packard, Sun, Microsoft and other Linuxdistributors.  These and othercompetitors are aggressively pursuing the current UNIX operating systemmarket.  Many of these competitors haveaccess to substantially greater resources than we do.  The major competitive alternatives to ourUNIX products are Microsoft Windows Server, Linux and other UNIX systems.  The expansion of Microsoft’s and our

 

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other competitors’ offeringsmay restrict the overall market available for our server products, includingsome markets where we have been successful in the past.

 

Our future success may depend in part on ourability to 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 of these and other competitive pressuresmay render our existing products and services obsolete, which would have an adverseimpact on our revenue and operations.

 

The success of our UNIX business will dependon the level of commitment and certification we receive from industry partnersand developers.  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 as a result of our SCOsourceinitiatives and in particular any lawsuit against end users violating ourintellectual property and contractual rights, such as our lawsuits againstAutoZone and DaimlerChrysler.

 

*Our compensationarrangement with the law firms representing us to enforce our intellectualproperty rights may reduce our ability to raise additional financing.*

 

Our compensation arrangement with the lawfirms representing us in our efforts to establish our intellectual propertyrights could inhibit our ability to raise additional funding if needed.  In addition to receiving fees at reducedhourly rates, our agreement with the law firms provides that the law firms willreceive a contingency fee of 20 percent of the proceeds from specifiedevents related to the protection of our intellectual property rights, and, ifwe reach a revised fee agreement with the law firms as currently contemplatedin the nonbinding letter of intent we have entered into with BSF, suchcontingency fee may reach 33 percent of such proceeds.  Events triggering a contingency fee mayinclude settlements, judgments, certain licensing fees, subject to certainexceptions, and a sale of our company during the pendancy of litigation orthrough settlement, subject to agreed upon credits for amounts received asdiscounted hourly fees and unused retainer fees.  Our current agreement with the law firms mayalso be construed to include contingency fee payments in connection withissuances of our equity securities. Future payments payable to the law firmsunder this arrangement may be significant. Our law firms’ right to receive suchcontingent payments could cause prospective investors to choose not to investin our company or limit the price at which new investors would be willing toprovide additional funds to our company. We may be unable to reach a definitive revised fee agreement with BSFthat reflects the terms of the nonbinding letter of intent as describedelsewhere in this filing.

 

*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, includingdevelopment facilities, sales personnel and customer support operations inEurope, Latin America and Asia.  Theseforeign operations are subject to certain inherent risks, including:

 

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

 

•                                          imposition of governmental controls, includingtrade restrictions and other tax requirements;

 

•                                          fluctuations in currency exchange rates andeconomic instability;

 

•                                          longer payment cycles for sales in foreigncountries;

 

•                                          seasonal reductions in business activity; and

 

•                                          political unrest, particularly in areas where wehave facilities.

 

In addition, certain of our operatingexpenses are denominated in local currencies, creating risk of foreign currencytranslation losses that could harm our financial results and cash flows. Whenwe generate profits in foreign countries, our effective income tax rate isincreased.

 

In Latin America and Asia in particular,several countries have suffered and may be especially susceptible to recessionsand economic 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.

 

During the second quarter of fiscal year2004, the Indian branch of our UK subsidiary was given a withholding taxassessment from the Government of India Income Tax Department.  The Tax Department assessed a 15 percent withholdingtax on certain revenue transactions in India that the Tax Department deemedroyalty revenue under the Income Tax Act. We have filed an appeal with the Tax Department and believe that ourpackaged software does not qualify for “royalties” treatment and thereforewould not be subject to withholding tax. However, we may be unsuccessful in our appeal against the Tax Departmentand be obligated to pay the assessed taxable amounts.  If other countries in which we haveinternational operations, such as India, continue to develop and begin enforcingtheir tax regimes, we may be subject to withholding or other taxes.

 

*If we are unable toretain key personnel in an intensely competitive environment, our operationscould be adversely affected.*

 

We need to retain our management, technical,and support personnel.  Competition forqualified professionals in the software industry is intense, and departures ofexisting personnel could be disruptive to our business and can 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 do not maintain key person insurance forany member of our management team.

 

*Our stock price is volatile.*

 

The tradingprice for our common stock has been volatile, ranging from a low closing salesprice of $1.09 in mid-February 2003, to a high closing sales price of $20.50per share in October 2003, to a current sales price of $3.89 on September 13,2004. The share price has changed dramatically over short periods withincreases and decreases of over 25 percent in a single day.  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

 

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business or litigationposition.  An investment in our stock issubject to such volatility and, consequently, is subject to significant risk.

 

*Risks associatedwith the potential exercise of our options outstanding.*

 

As of September 1, 2004, we have issued andoutstanding options to purchase up to approximately 3,478,000 shares of commonstock with exercise prices ranging from $0.76 to $28.00 per share.  The existence of such rights to acquirecommon stock at fixed prices may prove a hindrance to our efforts to raisefuture equity and debt funding, and the exercise of such rights will dilute thepercentage ownership interest of our stockholders and may dilute the value oftheir ownership.  The possible futuresale of shares issuable on the exercise of outstanding options could adverselyaffect the prevailing market price for our common stock.  Further, the holders of the outstandingrights may exercise them at a time when we would otherwise be able to obtainadditional equity capital on terms more favorable to us.

 

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

 

We have an effective registration statementrelating to the sale or distribution by BayStar and Royal Bank of Canada, aninitial  investor in our privateplacement of Series A shares (“RBC”) as selling stockholders of up to 3,703,704shares of common stock that were issuable upon conversion of our previouslyoutstanding Series A-1 shares, although the only shares of common stock issuedpursuant to the conversion of Series A-1 shares that may be sold or distributedpursuant to this registration statement are 740,740 shares issued to RBC.  Additionally, we have an effectiveregistration statement relating to the sale or distribution by BayStar as aselling stockholder of the 2,105,263 shares of common stock issued to BayStarin connection with our repurchase completed in July 2004 of all Series A-1shares previously held by BayStar.  Withrespect to either of these registration statements, we will not receive anyproceeds from the sales of the shares they cover.  The shares that may be sold or distributedpursuant to these registration statements represent approximately 12.1 percentof our issued and outstanding common stock as of September 1, 2004.

 

The sale of the block of stock covered by theregistration statement, or even the possibility of its sale, may adverselyaffect the trading market for our common stock and reduce the price availablein that market.  The shares of commonstock subject to our registration statements will, upon issuance, dilute theequity ownership percentage of the holders of our common stock.

 

*Our stock pricecould decline further because of the activities of short sellers.*

 

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

 

*The right of ourboard 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 theright, with respect to the 5,000,000 shares of our preferred stock, toauthorize the issuance of one or more additional series of our preferred stockwith 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.

 

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

 

We have adopted a Stockholder Rights Plan (“Rights Plan”) as describedelsewhere in this filing.  The powergiven to the Board of Directors by the Rights Plan may make it more difficultfor a change of control of our Company to occur or for the Company to beacquired when the acquisition is opposed by the Board of Directors.

 

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

 

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

 

*IBMCorporation*

 

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

 

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

 

IBM has fileda response and counterclaim to the complaint, including a demand for a jurytrial.  We have filed an answer to theIBM counterclaim denying the claims and asserting affirmative defenses.  OnFebruary 4, 2004, we filed a motion for leave to file amended pleadings inthe case proposing to amend our complaint against IBM and to modify ouraffirmative defenses against IBM’s counterclaims.  OnFebruary 25, 2004, the court granted our motion for leave to amend.  The second amended complaint, which was filedon February 27, 2004, alleges nine causes of action that are similar to thoseset forth above, adds a new claim for copyright infringement and removes theclaim for misappropriation of trade secrets. IBM filed an answer and counterclaim. The counterclaim filed by IBM asserts 14 claims against us.  In its counterclaim, as amended, IBMasserts that we do not have the right to terminate IBM’s UNIX license or assertclaims based on our ownership of UNIX intellectual property against IBM orothers in the Linux community.  Inaddition, IBM asserts we have breached the GNU General Public License and haveinfringed certain patents held by IBM. IBM’s counterclaims include claims forbreach of contract, violation of the Lanham Act, unfair competition,intentional interference with prospective economic relations, unfair anddeceptive trade practices, promissory estoppel, copyright infringement for adeclaratory judgment of non-infringement of copyrights, and patentinfringement.

 

On March 3, 2004, theU.S. Magistrate Judge issued an order addressing certain discovery mattersrelating to both us and IBM.  We havefiled a motion to dismiss IBM’s tenth counterclaim

 

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for a declaratory judgment ofnon-infringement of copyrights and a motion to amend the scheduling order and amotion to bifurcate IBM’s patent counterclaims into another action.  We filed, on May 28, 2004, a reply brief inconnection with our motion to amend the scheduling order, in which we set forthdetailed and specific responses to IBM’s claims made in connection with thatmotion.  A hearing for these motions washeld on June 8, 2004 and the court issued its ruling on June 10, 2004.

 

The court granted ourmotion to amend the scheduling order, with certain changes.  The amended scheduling order now provides,among other things, that the deadline for completing fact discovery is February11, 2005 (previously August 4, 2004), the deadline for completing expertdiscovery is April 22, 2005 (previously October 22, 2004), and the trial willbegin on November 1, 2005 (previously April 11, 2005).  The court also denied the motion to bifurcatethe patent counterclaims without prejudice to our right to request bifurcationagain at a later date.  IBM has alsofiled a motion for partial summary judgment on its tenth counterclaim for adeclaration of non-infringement of our copyrights.  A hearing regarding our motion to dismiss andIBM’s motion for partial summary judgment on IBM’s tenth counterclaim for adeclaration of non-infringement is currently scheduled for September 15,2004.  We plan to vigorously oppose IBM’smotion.  We have filed various motionsseeking additional discovery from IBM. IBM has filed two additional motions for summary judgment which we willvigorously oppose.  In addition to thematerials that have been publicly filed with the court, certain information hasbeen filed under seal in accordance with the protective order entered in thecase.

 

*Red Hat, Inc.*

 

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

 

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

 

*Novell, Inc.*

 

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

 

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Novell also filed a motion todismiss our complaint claiming it never transferred the copyrights to The SantaCruz Operation (now Tarantella, Inc.). We have filed a response to Novell’smotion to dismiss and have also filed a motion to remand the case back to thestate court.  On June 10, 2004, the courtissued a memorandum decision and order which denied our motion to remand thecase to state court.  The memorandumdecision also denied Novell’s motion to dismiss in part on claims offalsity.  However, the court grantedNovell’s motion to dismiss regarding our allegations of special damages, butgranted us 30 days leave to amend our complaint to plead special damages withmore specificity.  We have filed ouramended complaint and Novell has responded with another motion to dismissclaiming that Novell’s alleged slanderous statements are privileged under thelaw.  We plan to continue to vigorouslypursue our claims against Novell.

 

*DaimlerChrysler Corporation*

 

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

 

*AutoZone, Inc.*

 

On or about March 2, 2004, we brought suitagainst AutoZone, Inc. for its alleged violations of our UNIX copyrightsthrough its use of Linux.  Specifically,the lawsuit alleges that AutoZone is infringing our UNIX copyrights by, amongother things, running versions of the Linux operating system that contain code,structure, sequence and/or organization from our proprietary UNIX System V codein violation of our copyrights.  Thelawsuit filed in U.S. District Court in Nevada requests injunctive reliefagainst AutoZone’s further use or copying of any part of our copyrightedmaterials and also requests damages as a result of AutoZone’s infringement inan amount to be proven at trial.  OnApril 23, 2004, AutoZone filed a motion to transfer the case to Tennessee or tostay the case.  On August 6, 2004, thefederal court in Nevada entered an order granting AutoZone’s motion to stay thecase with 90-day status reports to the court. The court denied without prejudice AutoZone’s motion for a more definitestatement and its motion to transfer the case to Tennessee.  The court also is allowing the parties totake limited expedited discovery relating to the issue of preliminaryinjunctive relief requested by us.  Weare undertaking this discovery process.

 

*IPO Class Action Matter*

 

We are anissuer defendant in a series of class action lawsuits, involving over 300issuers that have been consolidated under *Inre Initial Public Offering Securities Litigation*, 21 MC 92(SAS).  The plaintiffs, the issuers andthe 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,

 

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and if no cross-claims,counterclaims or third party claims are later asserted, this action will bedismissed with respect to our directors and us.

 

We havenotified our underwriters and insurance companies of the existence of theclaims.  We believe, after consultationwith legal counsel, that the ultimate outcome of this matter will not have amaterial adverse effect on our results of operations or financialposition.  As of July 31, 2004, we havepaid or accrued the full retention amount of $200,000 under our insurance coverage.

 

*Other Matters*

 

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

 

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

 

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

 

*Issuance of common shares upon repurchase of SeriesA-1 shares.*

 

OnMay 31, 2004, we entered into an agreement with BayStar to repurchase andretire BayStar’s 40,000 Series A-1 shares. Terms of the agreement required us to pay to BayStar $13,000,000 in cashand issue 2,105,263 shares of our common stock. The repurchase price was payable and issuable upon the effectiveness ofa shelf registration statement covering the resale of the shares of commonstock that would be issued to BayStar upon the completion of the repurchase.  On July 21, 2004, the SEC declared theregistration statement on Form S-3 effective, and as of that date, thetransaction closed, all Series A-1 shares were cancelled, and we issued toBayStar 2,105,263 shares of common stock.

 

Weissued the unregistered, restricted shares of common stock (with respect towhich the resale was registered as of the closing of the repurchase) inreliance on the exemption from registration provided by Section 4(2) of theSecurities Act of 1933, as amended.

 

OnAugust 27, 2004, following the completion of the Series A-1 repurchasetransaction, after which no Series A-1 shares remained outstanding, we filed aCertificate of Elimination with the Secretary of State of the State ofDelaware.  The filing terminated the Certificateof Designation, Preferences and Rights of our Series A-1 shares, eliminatingthe previously designated Series A-1 shares.

 

*Repurchases of our common stock.*

 

OnMarch 10, 2004, our Board of Directors authorized the repurchase of up to1,500,000 shares of our common stock in open-market or privatetransactions.  The plan will remain in

 

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effect for a period of 24months from the date announced.  Therewere no repurchases of common stock during the three months ended July 31,2004.

 

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

 
| 3.1    | Amended and  Restated Certificate of Incorporation of Caldera International, Inc.  (incorporated by reference to Exhibit 3.1 to SCO’s Registration Statement on  Form 8-A12G/A (File No. 000-29911)).                                                  |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                        |
| 3.2    | Certificate  of Amendment to Amended and Restated Certificate of Incorporation regarding  consolidation of outstanding shares (incorporated by reference to Exhibit 3.2  to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).       |
|   |                                                                                                                                                                                                                                                        |
| 3.3    | Certificate  of Amendment to Amended and Restated Certificate of Incorporation regarding  change of name to The SCO Group, Inc. (incorporated by reference to Exhibit  3.3 to SCO’s Registration Statement on Form 8A12G/A (File No. 000–29911)). |
|   |                                                                                                                                                                                                                                                        |
| 3.4    | Amended and  Restated Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s  Registration Statement on Form 8-A12G/A (File No. 000–29911)).                                                                                                   |
|   |                                                                                                                                                                                                                                                        |
| 3.5    | Certificate  of Designation for Series A-1 Convertible Preferred Stock (incorporated by  reference to Exhibit 4.1 to SCO’s Current Report on Form 8-K filed on  February 9, 2004 (File No. 000-29911)).                                                |
|   |                                                                                                                                                                                                                                                        |
| 3.6    | Certificate  of Correction correcting the Certificate of Designation for Series A-1  Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to  SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No.  000-29911)).      |
|   |                                                                                                                                                                                                                                                        |
| 10.1   | Stock Repurchase Agreement dated as of May  31, 2004 between SCO and BayStar (incorporated by reference to Exhibit 99.1  to SCO’s Current Report on Form 8-K filed on June 2, 2004 (File No.  000-29911)).                                             |
|   |                                                                                                                                                                                                                                                        |
| 31.1   | Certification  of Darl C. McBride, President and Chief Executive Officer, pursuant to Rule  13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                           |
|   |                                                                                                                                                                                                                                                        |
| 31.2   | Certification  of Bert B. Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of the  Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                           |
|   |                                                                                                                                                                                                                                                        |
| 32.1   | Certification  of Darl C. McBride, President and Chief Executive Officer, pursuant to  Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.                                     |
|   |                                                                                                                                                                                                                                                        |
| 32.2   | Certification  of Bert B. Young, Chief Financial Officer, pursuant to Section 1350, Chapter  63 of Title 18, United States Code, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                     |

 

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

 

Pursuant tothe 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.

 

58

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| Date:  September 14, 2004 | THE SCO  GROUP, INC. |
|--------------------------------|----------------------|
|                           |                 |
|                           | By:                  | /s/  Bert B. Young |   |
|                           |                 | Bert B.  Young |
|                           |                 | Duly  Authorized Officer and |
|                           |                 | Chief  Financial Officer |
|                           |                 | (Principal  Financial and |
|                           |                 | Accounting  Officer) |

 

59

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                                    |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                       |
| 3.1                 |       | Amended and  Restated Certificate of Incorporation of Caldera International, Inc.  (incorporated by reference to Exhibit 3.1 to SCO’s Registration Statement on  Form 8-A12G/A (File No. 000-29911)).                                                 |
|                |       |                                                                                                                                                                                                                                                       |
| 3.2                 |       | Certificate  of Amendment to Amended and Restated Certificate of Incorporation regarding  consolidation of outstanding shares (incorporated by reference to Exhibit 3.2  to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).      |
|                |       |                                                                                                                                                                                                                                                       |
| 3.3                 |       | Certificate  of Amendment to Amended and Restated Certificate of Incorporation regarding  change of name to The SCO Group, Inc. (incorporated by reference to Exhibit  3.3 to SCO’s Registration Statement on Form 8A12G/A (File No. 000–29911). |
|                |       |                                                                                                                                                                                                                                                       |
| 3.4                 |       | Amended and  Restated Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s  Registration Statement on Form 8-A12G/A (File No. 000–29911)).                                                                                                  |
|                |       |                                                                                                                                                                                                                                                       |
| 3.5                 |       | Certificate  of Designation for Series A-1 Convertible Preferred Stock (incorporated by  reference to Exhibit 4.1 to SCO’s Current Report on Form 8-K filed on  February 9, 2004 (File No. 000-29911)).                                               |
|                |       |                                                                                                                                                                                                                                                       |
| 3.6                 |       | Certificate  of Correction correcting the Certificate of Designation for Series A-1  Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to  SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No.  000-29911)).     |
|                |       |                                                                                                                                                                                                                                                       |
| 10.1                |       | Stock Repurchase Agreement dated as of May  31, 2004 between SCO and BayStar (incorporated by reference to Exhibit 99.1  to SCO’s Current Report on Form 8-K filed on June 2, 2004 (File No.  000-29911)).                                            |
|                |       |                                                                                                                                                                                                                                                       |
| 31.1                |       | Certification  of Darl C. McBride, President and Chief Executive Officer, pursuant to Rule  13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                          |
|                |       |                                                                                                                                                                                                                                                       |
| 31.2                |       | Certification  of Bert B. Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of the  Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                          |
|                |       |                                                                                                                                                                                                                                                       |
| 32.1                |       | Certification  of Darl C. McBride, President and Chief Executive Officer, pursuant to  Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.                                    |
|                | ** ** | ** **                                                                                                                                                                                                                                                 |
| **32.2**            | ** ** | **Certification  of Bert B. Young, Chief Financial Officer, pursuant to Section 1350, Chapter  63 of Title 18, United States Code, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.**                                                |

 

60

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