**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

** **

**WASHINGTON, D.C. 20549**

** **

**FORM 10-Q/A**

**Amendment No. 1**

 

**(Markone)**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF**   | ** ** |
|------------|------------|-----------------------------------------------------------|------------|
| ** ** | ** ** | **THE SECURITIES EXCHANGE ACT OF 1934**                   | ** ** |
|       |       |                                                      |       |
| ** ** | ** ** | **For the quarterly period ended April 30, 2004**         | ** ** |
| ** ** | ** ** | ** **                                                | ** ** |
| ** ** | ** ** | **OR**                                                    | ** ** |
|       |       |                                                      |       |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF** | ** ** |
| ** ** | ** ** | **THE  SECURITIES EXCHANGE ACT OF 1934**                  | ** ** |

 

**For thetransition period from                 to                **

 

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

 

**THE SCOGROUP, INC.**

(Exact name of registrant as specified in its 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)       |

 

Indicateby check 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 ý NO o

 

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

 

YESo NO ý

 

*As of June 11, 2004, there were 15,335,432 shares of theRegistrant’s common stock, $0.001 par value per share, outstanding.*

 

 

----

 

**Explanatory Note**

 

The purpose of thisAmendment No. 1 to the Quarterly Report on Form 10-Q/A is to restate theCompany’s condensed consolidated financial statements for the three and sixmonths ended April 30, 2004 (the “Financial Statements”) and to modify therelated disclosures.  Please see Note 2to the Financial Statements included in the amended Form 10-Q.

 

The restatement arosefrom the Company’s determination that it has issued certain shares of itscommon stock under its equity compensation plans without complying with theregistration requirements of federal and applicable state securities laws.  As a result, the holders of such shares havea rescission right.  The Company hasdetermined that amounts received by the Company upon purchase of such sharesmust be reclassified from permanent equity to temporary equity.  Additionally, the Company corrected certainerrors in its accounting for accrued dividends related to the Company’s Series A Convertible Preferred Stock and the recording ofstock-based compensation.  The Companywill also reclassify an amount from cash and cash equivalents toavailable-for-sale securities to reflect the appropriate classification ofcertain auction rate securities.

 

Thisamended Form 10-Q/A does not attempt to modify or update any other disclosuresset forth in the original Form 10-Q, except as required to reflect the effectsof the restatement as described in Note 2 to the Financial Statements includedin the amended Form 10-Q/A. Additionally, this amended Form 10-Q/A, except forthe restatement information, speaks as of the filing date of the original Form10-Q and does not discuss any other Company developments after the date of theoriginal filing.  All informationcontained in this amended Form 10-Q/A and the original Form 10-Q is subject toupdating and supplementing as provided in the periodic reports that the Companyhas filed and will file after the original filing date with the Securities andExchange Commission.

 

2

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**The SCOGroup, Inc.**

 

**Tableof Contents**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                                        |   |
|----------|----------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.  | Unaudited Financial  Statements                                                                                                              |   |
|     | Condensed  Consolidated Balance Sheets as of April 30, 2004 and October 31, 2003                                                             |   |
|     | Condensed  Consolidated Statements of Operations and Comprehensive Income (Loss) for the  three and six months ended April 30, 2004 and 2003 |   |
|     | Condensed  Consolidated Statements of Cash Flows for the six months ended April 30, 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 Factors About Market Risk                                                                                      |   |
| Item 4.  | Controls and  Procedures                                                                                                                     |   |
|     | Forward-Looking Statements                                                                                                                   |   |
|     | Risk  Factors                                                                                                                                |   |
| PART II. | OTHER INFORMATION                                                                                                                            |   |
| Item 1.  | Legal Proceedings                                                                                                                            |   |
| Item  2. | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                 |   |
| Item  4. | Submission  of Matters to a Vote of Security Holders                                                                                         |   |
| Item 6.  | Exhibits and  Reports on Form 8-K                                                                                                            |   |
| Item 7.  | Signatures                                                                                                                                   |   |

 

3

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**THE SCO GROUP, INC. ANDSUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(unaudited,in thousands)**

 
| ** **                                                                                                                | ** ** | **April 30,  2004**          | ** ** | **October 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                | ** ** | **(Restated -  see Note 2)** | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                | ** ** | ** **                   | ** ** | ** **            | ** ** |
|                                                                                                                      |       |                         |       |                  |       |
| CURRENT  ASSETS:                                                                                                          |       |                         |       |                  |       |
| Cash  and cash equivalents                                                                                                |       | $                            | 21,042     |                  | $          | 64,428 |   |
| Restricted  cash                                                                                                          |       | 3,203                        |       | 2,025                 |       |
| Available-for-sale  securities                                                                                            |       | 40,304                       |       | 4,095                 |       |
| Accounts  receivable, net of allowance for doubtful accounts of $155 and $230,  respectively                              |       | 6,811                        |       | 9,282                 |       |
| Other  current assets                                                                                                     |       | 2,531                        |       | 2,450                 |       |
| Total  current assets                                                                                                     |       | 73,891                       |       | 82,280                |       |
|                                                                                                                      |       |                         |       |                  |       |
| PROPERTY  AND EQUIPMENT:                                                                                                  |       |                         |       |                  |       |
| Computer  and office equipment                                                                                            |       | 3,660                        |       | 3,482                 |       |
| Leasehold  improvements                                                                                                   |       | 633                          |       | 608                   |       |
| Furniture  and fixtures                                                                                                   |       | 210                          |       | 189                   |       |
|                                                                                                                      |       | 4,503                        |       | 4,279                 |       |
| Less  accumulated depreciation and amortization                                                                           |       | (3,631                       | )          | (3,131                | )          |
| Net  property and equipment                                                                                               |       | 872                          |       | 1,148                 |       |
|                                                                                                                      |       |                         |       |                  |       |
| OTHER  ASSETS:                                                                                                            |       |                         |       |                  |       |
| Goodwill                                                                                                                  |       | —                       |       | 1,166                 |       |
| Intangibles,  net                                                                                                         |       | 6,767                        |       | 9,286                 |       |
| Other  assets, net                                                                                                        |       | 1,347                        |       | 1,072                 |       |
| Total  other assets                                                                                                       |       | 8,114                        |       | 11,524                |       |
|                                                                                                                      |       |                         |       |                  |       |
| Total  assets                                                                                                             |       | $                            | 82,877     |                  | $          | 94,952 |   |
|                                                                                                                      |       |                         |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS' EQUITY**                                                                                  | ** ** | ** **                   | ** ** | ** **            | ** ** |
|                                                                                                                      |       |                         |       |                  |       |
| CURRENT  LIABILITIES:                                                                                                     |       |                         |       |                  |       |
| Accounts  payable                                                                                                         |       | $                            | 2,831      |                  | $          | 1,978 |   |
| Royalty  payable to Novell, Inc.                                                                                          |       | 3,203                        |       | 2,025                 |       |
| Accrued  compensation to law firms                                                                                        |       | 7,956                        |       | 10,556                |       |
| Accrued  payroll and benefits                                                                                             |       | 3,868                        |       | 4,752                 |       |
| Accrued  liabilities                                                                                                      |       | 8,744                        |       | 3,754                 |       |
| Derivative  related to redeemable convertible preferred stock                                                             |       | —                       |       | 15,224                |       |
| Deferred  revenue                                                                                                         |       | 7,554                        |       | 5,501                 |       |
| Other  royalties payable                                                                                                  |       | 309                          |       | 523                   |       |
| Taxes  payable                                                                                                            |       | 1,489                        |       | 799                   |       |
| Total  current liabilities                                                                                                |       | 35,954                       |       | 45,112                |       |
|                                                                                                                      |       |                         |       |                  |       |
| LONG-TERM  LIABILITIES                                                                                                    |       | 535                          |       | 508                   |       |
|                                                                                                                      |       |                         |       |                  |       |
| MINORITY  INTEREST                                                                                                        |       | —                       |       | 145                   |       |
|                                                                                                                      |       |                         |       |                  |       |
| COMMITMENTS  AND CONTINGENCIES (Note 6)                                                                                   |       |                         |       |                  |       |
|                                                                                                                      |       |                         |       |                  |       |
| SERIES  A-1 REDEEMABLE CONVERTIBLE PREFERRED STOCK,  $0.001 par value, 50 and 0 shares outstanding, respectively (Note 7) |       | 45,065                       |       | —                |       |
|                                                                                                                      |       |                         |       |                  |       |
| SERIES  A REDEEMABLE CONVERTIBLE PREFERRED STOCK,  $0.001 par value, 0 and 50 shares outstanding, respectively (Note 7)   |       | —                       |       | 29,671                |       |
|                                                                                                                      |       |                         |       |                  |       |
| COMMON  STOCK SUBJECT TO RESCISSION (Note 8)                                                                              |       | 231                          |       | —                |       |
|                                                                                                                      |       |                         |       |                  |       |
| STOCKHOLDERS'  EQUITY:                                                                                                    |       |                         |       |                  |       |
| Common  stock, $0.001 par value; 45,000 shares authorized, 14,521 and 13,824 shares  outstanding, respectively            |       | 15                           |       | 14                    |       |
| Additional  paid-in capital                                                                                               |       | 218,143                      |       | 218,690               |       |
| Common  stock held in treasury                                                                                            |       | (2,414                       | )          | —                |       |
| Warrants  outstanding                                                                                                     |       | 1,099                        |       | 1,099                 |       |
| Deferred  compensation                                                                                                    |       | (124                         | )          | (347                  | )          |
| Accumulated  other comprehensive income                                                                                   |       | 956                          |       | 926                   |       |
| Accumulated  deficit                                                                                                      |       | (216,583                     | )          | (200,866              | )          |
| Total  stockholders' equity                                                                                               |       | 1,092                        |       | 19,516                |       |
|                                                                                                                      |       |                         |       |                  |       |
| Total  liabilities and stockholders' equity                                                                               |       | $                            | 82,877     |                  | $          | 94,952 |   |

 

See notes to condensed consolidated financial statements.

 

4

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

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME(LOSS)**

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

 
| ** **                                                                                                      | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                      | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                      | ** ** | **(Restated -  see Note 2)**     | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| REVENUE:                                                                                                        |       |                             |       |                           |       |   |   |   |   |
| Products                                                                                                        |       | $                                | 8,415      |                           | $          | 11,122 |   | $ | 18,127 |   | $ | 22,212 |   |
| SCOsource  licensing                                                                                            |       | 11                               |       | 8,250                          |       | 31 |   | 8,250 |   |
| Services                                                                                                        |       | 1,711                            |       | 1,997                          |       | 3,371 |   | 4,447 |   |
| Total  revenue                                                                                                  |       | 10,137                           |       | 21,369                         |       | 21,529 |   | 34,909 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| COST  OF REVENUE:                                                                                               |       |                             |       |                           |       |   |   |   |   |
| Products                                                                                                        |       | 901                              |       | 1,206                          |       | 1,789 |   | 2,392 |   |
| SCOsource  licensing                                                                                            |       | 4,484                            |       | 2,163                          |       | 7,924 |   | 2,163 |   |
| Services                                                                                                        |       | 1,073                            |       | 1,778                          |       | 2,395 |   | 3,470 |   |
| Total  cost of revenue                                                                                          |       | 6,458                            |       | 5,147                          |       | 12,108 |   | 8,025 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| GROSS  MARGIN                                                                                                   |       | 3,679                            |       | 16,222                         |       | 9,421 |   | 26,884 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| OPERATING  EXPENSES:                                                                                            |       |                             |       |                           |       |   |   |   |   |
| Sales  and marketing (exclusive of stock-based compensation of $29, $34, $47 and  $68, respectively)            |       | 4,698                            |       | 6,051                          |       | 9,719 |   | 12,491 |   |
| Research  and development (exclusive of stock-based compensation of $12, $31, $23 and  $54, respectively)       |       | 2,868                            |       | 2,542                          |       | 5,575 |   | 5,192 |   |
| General  and administrative (exclusive of stock-based compensation of $122, $341, $528  and $496, respectively) |       | 2,392                            |       | 1,462                          |       | 4,586 |   | 3,112 |   |
| Restructuring  charges (reversals)                                                                              |       | —                           |       | 136                            |       | — |   | (116 | ) |
| Amortization  of intangibles                                                                                    |       | 593                              |       | 700                            |       | 1,380 |   | 1,400 |   |
| Loss  on impairment of long-lived assets                                                                        |       | 2,139                            |       | —                         |       | 2,139 |   | — |   |
| Stock-based  compensation                                                                                       |       | 163                              |       | 406                            |       | 598 |   | 618 |   |
| Total  operating expenses                                                                                       |       | 12,853                           |       | 11,297                         |       | 23,997 |   | 22,697 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| INCOME  (LOSS) FROM OPERATIONS                                                                                  |       | (9,174                           | )          | 4,925                          |       | (14,576 | ) | 4,187 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| EQUITY  IN INCOME (LOSSES) OF AFFILIATES                                                                        |       | 37                               |       | (75                            | )          | 74 |   | (100 | ) |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| OTHER  INCOME (EXPENSE):                                                                                        |       |                             |       |                           |       |   |   |   |   |
| Interest  income                                                                                                |       | 242                              |       | 11                             |       | 512 |   | 50 |   |
| Change  in fair value of derivative (Note 7)                                                                    |       | 2,300                            |       | —                         |       | 5,924 |   | — |   |
| Other  income (expense), net                                                                                    |       | (120                             | )          | (59                            | )          | (251 | ) | (54 | ) |
| Total  other income (expense), net                                                                              |       | 2,422                            |       | (48                            | )          | 6,185 |   | (4 | ) |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| INCOME  (LOSS) BEFORE INCOME TAXES                                                                              |       | (6,715                           | )          | 4,802                          |       | (8,317 | ) | 4,083 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| PROVISION  FOR INCOME TAXES                                                                                     |       | (966                             | )          | (302                           | )          | (1,094 | ) | (307 | ) |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| NET  INCOME (LOSS)                                                                                              |       | (7,681                           | )          | 4,500                          |       | (9,411 | ) | 3,776 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| DIVIDENDS  ON REDEEMABLE CONVERTIBLE PREFERRED STOCK                                                            |       | (7,045                           | )          | —                         |       | (7,801 | ) | — |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| NET  INCOME (LOSS) APPLICABLE TO COMMON STOCKHOLDERS                                                            |       | $                                | (14,726    | )                              | $          | 4,500 |   | $ | (17,212 | ) | $ | 3,776 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| BASIC  NET INCOME (LOSS) PER COMMON SHARE                                                                       |       | $                                | (1.04      | )                              | $          | 0.39 |   | $ | (1.23 | ) | $ | 0.33 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| DILUTED  NET INCOME (LOSS) PER COMMON SHARE                                                                     |       | $                                | (1.04      | )                              | $          | 0.33 |   | $ | (1.23 | ) | $ | 0.29 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| WEIGHTED  AVERAGE BASIC COMMON SHARES OUTSTANDING                                                               |       | 14,100                           |       | 11,561                         |       | 13,960 |   | 11,402 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| WEIGHTED  AVERAGE DILUTED COMMON SHARES OUTSTANDING                                                             |       | 14,100                           |       | 13,663                         |       | 13,960 |   | 13,145 |   |
|                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| OTHER  COMPREHENSIVE INCOME (LOSS)                                                                              |       |                             |       |                           |       |   |   |   |   |
| Net  income (loss)                                                                                              |       | $                                | (7,681     | )                              | $          | 4,500 |   | $ | (9,411 | ) | $ | 3,776 |   |
| Unrealized  loss on available-for-sale securities                                                               |       | (99                              | )          | —                         |       | (118 | ) | — |   |
| Foreign  currency translation adjustment                                                                        |       | 138                              |       | 69                             |       | 148 |   | 226 |   |
| COMPREHENSIVE  INCOME (LOSS)                                                                                    |       | $                                | (7,642     | )                              | $          | 4,569 |   | $ | (9,381 | ) | $ | 4,002 |   |

 

See notes to condensed consolidated financial statements.

 

5

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**THESCO GROUP, INC. AND SUBSIDIARIES**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited, in thousands)**

 
| ** **                                                                                           | ** ** | **Six Months Ended April 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                           | ** ** | **2004**                       | ** ** | **2003** | ** ** |
| ** **                                                                                           | ** ** | **(Restated -  see Note 2)**   | ** ** | ** ** | ** ** |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                               |       |                           |       |   |   |
| Net  income (loss)                                                                                   |       | $                              | (9,411     | ) | $ | 3,776 |   |
| 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 $166 and $169 classified as cost of revenue)                 |       | 1,546                          |       | 1,569 |   |
| Depreciation  and other amortization                                                                 |       | 435                            |       | 604 |   |
| Stock-based  compensation                                                                            |       | 598                            |       | 618 |   |
| Equity  in (income) losses of affiliates                                                             |       | (74                            | )          | 100 |   |
| Changes  in operating assets and liabilities                                                         |       |                           |       |   |   |
| Accounts  receivable, net                                                                            |       | 2,471                          |       | (348 | ) |
| Other  current assets                                                                                |       | (81                            | )          | 1,193 |   |
| Other  assets                                                                                        |       | (201                           | )          | 493 |   |
| Accounts  payable                                                                                    |       | 853                            |       | (217 | ) |
| Accrued  payroll and benefits                                                                        |       | (884                           | )          | (18 | ) |
| Accrued  compensation to law firms                                                                   |       | (2,600                         | )          | — |   |
| Accrued  liabilities                                                                                 |       | 3,371                          |       | (2,034 | ) |
| Deferred  revenue                                                                                    |       | 2,053                          |       | (838 | ) |
| Other  royalties payable                                                                             |       | (214                           | )          | (205 | ) |
| Taxes  payable                                                                                       |       | 690                            |       | 49 |   |
| Long-term  liabilities                                                                               |       | 27                             |       | (1,569 | ) |
| Net  cash provided by (used in) operating activities                                                 |       | (5,206                         | )          | 3,173 |   |
|                                                                                                 |       |                           |       |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                               |       |                           |       |   |   |
| Purchase  of property and equipment                                                                  |       | (186                           | )          | (328 | ) |
| Purchase  of available-for-sale securities                                                           |       | (41,234                        | )          | — |   |
| Proceeds  from available-for-sale securities                                                         |       | 5,025                          |       | — |   |
| Purchase  of minority interest in Japanese subsidiary                                                |       | (209                           | )          | — |   |
| Investment  in non-marketable securities                                                             |       | —                         |       | (450 | ) |
| Net  cash used in investing activities                                                               |       | (36,604                        | )          | (778 | ) |
|                                                                                                 |       |                           |       |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                               |       |                           |       |   |   |
| Proceeds  from sale of common stock through ESPP                                                     |       | 370                            |       | 57 |   |
| Offering  costs incurred in connection with Series A-1 issuance                                      |       | (212                           | )          | — |   |
| Purchase  of common stock                                                                            |       | (2,414                         | )          | — |   |
| Net  proceeds from the issuance of a warrant                                                         |       | —                         |       | 500 |   |
| Proceeds  from exercise of common stock options                                                      |       | 559                            |       | 225 |   |
| Net  cash provided by (used in) financing activities                                                 |       | (1,697                         | )          | 782 |   |
|                                                                                                 |       |                           |       |   |   |
| NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                |       | (43,507                        | )          | 3,177 |   |
| EFFECT  OF FOREIGN EXCHANGE RATES ON CASH                                                            |       | 121                            |       | 249 |   |
| CASH  AND CASH EQUIVALENTS, beginning of period                                                      |       | 64,428                         |       | 6,589 |   |
| CASH  AND CASH EQUIVALENTS, end of period                                                            |       | $                              | 21,042     |   | $ | 10,015 |   |
|                                                                                                 |       |                           |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                                   |       |                           |       |   |   |
|                                                                                                 |       |                           |       |   |   |
| Cash  paid for taxes                                                                                 |       | $                              | 274        |   | $ | 249 |   |
|                                                                                                 |       |                           |       |   |   |
| SUPPLEMENTAL  SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:                                |       |                           |       |   |   |
|                                                                                                 |       |                           |       |   |   |
| Accretion  of dividends                                                                              |       | $                              | 1,496      |   | $ | — |   |
|                                                                                                 |       |                           |       |   |   |
| Dividend  in connection with exchange of Series A-1 for Series A                                     |       | $                              | 6,305      |   | $ | — |   |
|                                                                                                 |       |                           |       |   |   |
| Common  stock subject to rescission                                                                  |       | $                              | 231        |   | $ | — |   |

 

See notes to condensed consolidated financial statements.

 

6

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

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

## ** **

The SCO Group, Inc.’s (the “Company”)business focuses on marketing reliable, cost-effective UNIX software productsand related services for the small-to-medium sized business market.  In January 2003, the Company established itsSCOsource division and launched its first of several SCOsource initiatives toreview and enforce its intellectual property surrounding the UNIX operatingsystem. The Company acquired certain intellectual property rights surroundingUNIX and UNIX System V source code from The Santa Cruz Operation (nowTarantella, Inc.) in May 2001.

 

**(2) RESTATEMENT OF FINANCIALSTATEMENTS**

 

The Company’s previouslyissued condensed consolidated financial statements as of and for the three andsix months ended April 30, 2004 have been restated to correct the accountingfor the following items:

 

•                  Reclassifying$1,619,000 of accrued dividends from equity to current liabilities related tothe Company’s outstanding shares of Series AConvertible Preferred Stock.  The accrueddividends had previously been recorded incorrectly in equity.  The accrued dividends were never paid andwere properly captured in the calculation of earnings per share in the periodsabove;

 

•                  Reclassifyingfrom permanent equity to temporary equity $231,000 related to certain shares ofcommon stock issued under the Company’s equity compensation plans that aresubject to rescission because they were issued without appropriate registrationunder applicable securities laws.  As aresult, certain plan participants have a right to rescind their purchase ofshares or recover damages if they no longer own the shares.  Holders of such shares have a rescissionright against the Company and the exercise of such rescission right may dependin part on the price of the Company’s common stock which is outside both theCompany’s and the holders’ control.  Thereclassification amount of $231,000 in the aggregate, excluding interest andother possible fees was based upon shares outstanding as of April 30, 2004; and

 

•                  Recordingin the first quarter of fiscal year 2004 stock-based compensation of $233,000incurred by issuing an equity award to a consultant whichpreviously had been recorded in the Company’s condensed consolidated financialstatements for the second quarter of fiscal year 2004.

 

In addition to the aboverestatement items, the Company has made a reclassification of $24,654,000 fromcash and cash equivalents to available-for-sale securities to reflect theappropriate classification of certain auction rate securities as the originalmaturity of these securities is greater than three months.

 

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The following tablesummarizes the effect of the restatement and reclassification adjustments onthe Financial Statements as of and for the three and six months ended April 30,2004 (in thousands, except per share amounts):

 
| ** **                                   | ** ** | **Three Months Ended April 30,** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **2004**                         | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **(Previously  Reported)**       | ** ** | **(Restated)** | ** ** |
| Stock-based  compensation                    |       | $                                | 396        |   | $ | 163 |   |
| Total  operating expenses                    |       | 13,086                           |       | 12,853 |   |
| Loss  from operations                        |       | (9,407                           | )          | (9,174 | ) |
| Loss  before income taxes                    |       | (6,948                           | )          | (6,715 | ) |
| Net  loss                                    |       | (7,914                           | )          | (7,681 | ) |
| Net  loss applicable to common stockholders  |       | (14,959                          | )          | (14,726 | ) |
| Basic  and diluted net loss per common share |       | $                                | (1.06      | ) | $ | (1.04 | ) |
| * *                                     | * *   | * *                         | * *   | * * | * * |
| ** **                                   | ** ** | **Six Months Ended April 30,**   | ** ** |
| ** **                                   | ** ** | **2004**                         | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **(Previously  Reported)**       | ** ** | **(Restated)** | ** ** |
| Net  cash used in investing activities       |       | $                                | (11,950    | ) | $ | (36,604 | ) |
|                                         |       |                             |       |   |   |
| ** **                                   | ** ** | **As of April 30,**              | ** ** |
| ** **                                   | ** ** | **2004**                         | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **(Previously  Reported)**       | ** ** | **(Restated)** | ** ** |
| Cash  and equivalents                        |       | $                                | 45,696     |   | $ | 21,042 |   |
| Available-for-sale  securities               |       | 15,650                           |       | 40,304 |   |
| Accrued  liabilities                         |       | 7,125                            |       | 8,744 |   |
| Total  current liabilities                   |       | 34,335                           |       | 35,954 |   |
| Common  stock subject to rescission          |       | —                           |       | 231 |   |
| Additional  paid-in capital                  |       | 219,993                          |       | 218,143 |   |
| Total  stockholders’ equity             |       | 2,942                            |       | 1,092 |   |

 

The Company’s previouslyissued notes to condensed consolidated financial statements for the three andsix months ended April 30, 2004 have been restated to correct the accountingfor the following item:

 

•                  Restatingthe pro forma fair value of stock-based compensation in the notes to condensedconsolidated financial statements for the three and six months ended April 30,2004 by $50,000 and $354,000, respectively, to appropriately include the fairvalue of certain equity awards that were not correctly included in the originaldisclosure.

 

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The following tablesummarizes the effect of this restatement adjustment on the notes to condensedconsolidated financial statements for the three and six months ended April 30,2004 (in thousands, except per share amounts):

 
| ** **                                                            | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                            | ** ** | **2004**                         | ** ** | **2004** | ** ** |
| ** **                                                            | ** ** | **(Previously  Reported)**       | ** ** | **(Restated)** | ** ** |
| Net  loss applicable to common stockholders:                          |       |                             |       |   |   |
| As  reported                                                          |       | $                                | (14,959    | ) | $ | (14,726 | ) |
| Stock-based  compensation as reported                                 |       | 396                              |       | 163 |   |
| Stock-based  compensation under fair value method                     |       | (426                             | )          | (476 | ) |
| Pro  forma net loss                                                   |       | $                                | (14,989    | ) | $ | (15,039 | ) |
|                                                                  |       |                             |       |   |   |
| Net  loss applicable to common stockholders per diluted common share: |       |                             |       |   |   |
| As  reported                                                          |       | $                                | (1.06      | ) | $ | (1.04 | ) |
| Pro  forma                                                            |       | $                                | (1.06      | ) | $ | (1.07 | ) |
|                                                                  |       |                             |       |   |   |
| ** **                                                            | ** ** | **Six Months Ended April 30,**   | ** ** |
| ** **                                                            | ** ** | **2004**                         | ** ** | **2004** | ** ** |
| ** **                                                            | ** ** | **(Previously  Reported)**       | ** ** | **(Restated)** | ** ** |
| Net  loss applicable to common stockholders:                          |       |                             |       |   |   |
| As  reported                                                          |       | $                                | (17,212    | ) | $ | (17,212 | ) |
| Stock-based  compensation as reported                                 |       | 598                              |       | 598 |   |
| Stock-based  compensation under fair value method                     |       | (929                             | )          | (1,283 | ) |
| Pro  forma net loss                                                   |       | $                                | (17,543    | ) | $ | (17,897 | ) |
|                                                                  |       |                             |       |   |   |
| Net  loss applicable to common stockholders per diluted common share: |       |                             |       |   |   |
| As  reported                                                          |       | $                                | (1.23      | ) | $ | (1.23 | ) |
| Pro  forma                                                            |       | $                                | (1.26      | ) | $ | (1.28 | ) |

 

## **(3) SIGNIFICANT ACCOUNTINGPOLICIES**

 

### **Basis of Presentation**

 

The accompanying unaudited condensed consolidatedfinancial statements of the Company have been prepared by the Company pursuantto the rules and regulations of the Securities and Exchange Commission (“SEC”)on a basis consistent with the Company’s audited annual financial statements,and, 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 the UnitedStates of America have been condensed or omitted pursuant to SEC rules andregulations, although the Company believes that the following disclosures, whenread in conjunction with the audited annual financial statements and the notesthereto included in the Company’s most recent annual report on Form 10-K, areadequate to make the information presented not misleading.  Operating

 

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resultsfor the three and six months ended April 30, 2004 are not necessarilyindicative of the results that may be expected for the year ending October 31,2004.

 

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

### ** **

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

 

### **Revenue Recognition**

### ** **

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

 

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

 

The majority of the Company’s revenue transactionsrelate to product-only sales.  Onoccasion, the Company has revenue transactions that have multiple elements(i.e., 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 set forthabove have been met.  If VSOE of allundelivered elements exists, but VSOE does not exist for one or more deliveredelements, 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 education and consulting services is recognized as the related servicesare performed.

 

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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 are received.

 

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

 

The Company accounts for stock options issued todirectors, officers and employees under Accounting Principles Board (“APB”) No.25.  Under APB No. 25, compensationexpense is recognized if an option’s exercise price on the measurement date isbelow the fair 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 netincome (loss) to common stockholders as if the Company had accounted for itsstock options granted under the fair value method.  The fair value for the Company’s stockoptions is estimated on the date of grant using the Black-Scholesoption-pricing model.

 

With respect to stockoptions, restricted stock awards granted and employee stock purchase program (“ESPP”)shares purchased during the three and six months ended April 30, 2004 and 2003,the assumptions used are listed in the following table: 

** **
| ** **                | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|---------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Risk-free  interest rate  |       | 2.9                              | %          | 2.9                            | %          | 2.6 | % | 2.9 | % |
| Expected  dividend yield  |       | 0.0                              | %          | 0.0                            | %          | 0.0 | % | 0.0 | % |
| Volatility                |       | 91.5                             | %          | 142.0                          | %          | 82.4 | % | 115.0 | % |
| Expected  life (in years) |       | 3.0                              |       | 2.3                            |       | 3.0 |   | 2.3 |   |

 

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For purposes of the pro formadisclosure, the estimated fair value of the stock options,restricted stock awards and ESPP shares are amortized over the vesting periodof the award.  The following is the proforma disclosure and the related impact on net income (loss) and the net income(loss) per diluted common share for the three and six months ended April 30,2004 and 2003 (in thousands, except per share amounts):****

 
| ** **                                                                     | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                     | ** ** | **(restated)**                   | ** ** | ** **                     | ** ** | **(restated)** | ** ** | ** ** | ** ** |
| Net  income (loss) applicable to common stockholders:                          |       |                             |       |                           |       |   |   |   |   |
| As  reported                                                                   |       | $                                | (14,726    | )                              | $          | 4,500 |   | $ | (17,212 | ) | $ | 3,776 |   |
| Stock-based  compensation as reported                                          |       | 163                              |       | 406                            |       | 598 |   | 618 |   |
| Stock-based  compensation under fair value method                              |       | (476                             | )          | (412                           | )          | (1,283 | ) | (975 | ) |
| Pro  forma net income (loss)                                                   |       | $                                | (15,039    | )                              | $          | 4,494 |   | $ | (17,897 | ) | $ | 3,419 |   |
|                                                                           |       |                             |       |                           |       |   |   |   |   |
| Net  income (loss) applicable to common stockholders per diluted common share: |       |                             |       |                           |       |   |   |   |   |
| As  reported                                                                   |       | $                                | (1.04      | )                              | $          | 0.33 |   | $ | (1.23 | ) | $ | 0.29 |   |
| Pro  forma                                                                     |       | $                                | (1.07      | )                              | $          | 0.33 |   | $ | (1.28 | ) | $ | 0.26 |   |

 

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

 

The Company considers all highly liquid debtinstruments purchased with original maturities of three or fewer months to becash equivalents.  Cash equivalents were$18,129,000 as of April 30, 2004 and $61,701,000 as of October 31, 2003, whichprimarily consisted of investments in money market funds, commercial paper,corporate notes and agencies.

 

**NetIncome (Loss) per Common Share**

 

Basic net income (loss) per common share (“Basic EPS”)is computed by dividing net income (loss) by the weighted average number ofcommon shares outstanding.  Diluted netincome (loss) per common share (“Diluted EPS”) is computed by dividing netincome (loss) by the sum of the weighted average number of common sharesoutstanding and the dilutive potential common share equivalents thenoutstanding.  Potential common shareequivalents consist of the weighted average of shares issuable upon theexercise of outstanding stock options, restricted stock awards, issued shares of redeemable A-1 Convertible Preferred Stockand warrants to acquire common stock.  The excluded anti-dilutive common share equivalents are not included inthe computation of Diluted EPS as their effect would have decreased DilutedEPS.

 

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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 April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                 |       | **(restated)**                   |       |                           |       |   |   |   |   |
| Numerator:                                           |       |                             |       |                           |       |   |   |   |   |
| Net  income (loss) applicable to common stockholders |       | $                                | (14,726    | )                              | $          | 4,500 |   | $ | (17,212 | ) | $ | 3,776 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Denominator:                                         |       |                             |       |                           |       |   |   |   |   |
| Weighted  average common shares outstanding          |       | 14,100                           |       | 11,561                         |       | 13,960 |   | 11,402 |   |
| Effect  of stock options                             |       | —                           |       | 1,779                          |       | — |   | 1,476 |   |
| Effect  of restricted stock awards                   |       | —                           |       | 299                            |       | — |   | 255 |   |
| Effect  of warrant                                   |       | —                           |       | 24                             |       | — |   | 12 |   |
| Total                                                |       | 14,100                           |       | 13,663                         |       | 13,960 |   | 13,145 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Basic  EPS                                           |       | $                                | (1.04      | )                              | $          | 0.39 |   | $ | (1.23 | ) | $ | 0.33 |   |
| Diluted  EPS                                         |       | $                                | (1.04      | )                              | $          | 0.33 |   | $ | (1.23 | ) | $ | 0.29 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Excluded  anti-dilutive common share equivalents     |       | 6,665                            |       | 628                            |       | 6,665 |   | 987 |   |

 

**(4) GOODWILL AND INTANGIBLE ASSETS**

 

The following table summarizes the components ofamortized intangible assets and their useful lives as of October 31, 2003 (inthousands):

 
| ** **                      | ** ** | ** **                 | ** ** | **As of October 31, 2003,** | ** ** |
|---------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                      | ** ** | **Estimated  Useful Life** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** |
| Amortizable  intangible assets: |       |                       |       |                        |       |   |   |   |   |
| Distribution/reseller  channel  |       | 5 years                    |       | $                           | 11,626     |   | $ | 4,672 |   | $ | 6,954 |   |
| Acquired  technology            |       | 5 years                    |       | 1,687                       |       | 678 |   | 1,009 |   |
| Acquired  technology            |       | 2 years                    |       | 1,555                       |       | 389 |   | 1,166 |   |
| Trade  name                     |       | 5 years                    |       | 262                         |       | 105 |   | 157 |   |
| Total  intangible assets        |       |                       |       | $                           | 15,130     |   | $ | 5,844 |   | $ | 9,286 |   |

 

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The following table shows the activity related toamortized intangible assets for the six months ended April 30, 2004 andremaining unamortized balances as of April 30, 2004 (in thousands):

 
| ** **                      | ** ** | **As of  October 31, 2003** | ** ** | **Six Months Ended  April 30, 2004** | ** ** | **As of  April 30, 2004** | ** ** |
|---------------------------------|------------|-----------------------------|------------|--------------------------------------|------------|---------------------------|------------|
| ** **                      | ** ** | ** **                  | ** ** | **Amortization**                     | ** ** | **Impairment**            | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Net Book Value**          | ** ** | **Expense**                          | ** ** | **Loss**                  | ** ** | **Net Book Value** | ** ** |
| Amortizable  intangible assets: |       |                        |       |                                 |       |                      |       |   |   |
| Distribution/reseller  channel  |       | $                           | 6,954      |                                 | $          | 1,159                     |       | $ | — |   | $ | 5,795 |   |
| Acquired  technology            |       | 1,009                       |       | 168                                  |       | —                    |       | 841 |   |
| Acquired  technology            |       | 1,166                       |       | 193                                  |       | 973                       |       | — |   |
| Trade  name                     |       | 157                         |       | 26                                   |       | —                    |       | 131 |   |
| Total  intangible assets        |       | $                           | 9,286      |                                 | $          | 1,546                     |       | $ | 973 |   | $ | 6,767 |   |

 

Of the $1,546,000 in amortization expense, $1,380,000was classified as amortization of intangible assets in operating expenses andthe remaining $166,000 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 three and six months ended April 30, 2004.  The impairment related to goodwill andintangible assets 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-alonebasis.  Consequently, the Company hasconcluded that no significant future cash flows related to its Vultus assetswould be realized.  The Company performedan impairment analysis of its recorded goodwill related to the Vultus reportingunit in accordance with SFAS No. 142. Additionally, an impairment analysis of the intangible assets wasperformed in accordance with SFAS No. 144. As a result of these analyses, the Company wrote-down the carrying valueof its goodwill related to the Vultus acquisition from $1,166,000 to $0 andwrote-down intangible assets related to its Vultus acquisition from $973,000 to$0.

 

**(5)RESTRUCTURING PLANS**

 

The Company’s board of directors and management hasadopted restructuring plans to reduce facilities and personnel.  These restructuring plans have resulted inthe Company 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 and theexiting of one small facility.

 

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The following table summarizes the activity related tothe restructuring accruals as of April 30, 2004 (in thousands): 

 
| ** ** | ** ** | **Balance as of  October 31,  2003** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Payments** | ** ** | **Balance as of  April 30,  2004** | ** ** |
|------------|------------|--------------------------------------|------------|---------------|------------|-----------------|------------|--------------|------------|------------------------------------|------------|
|       |       |                                 |       |          |       |            |       |         |       |                               |       |
| Facilities |       | $                                    | 348        |          | $          | 39              |       | $            | —     |                               | $          | (145 | ) | $ | 242 |   |
| Employees  |       | —                               |       | 643           |       | —          |       | (242         | )          | 401                                |       |
| Total      |       | $                                    | 348        |          | $          | 682             |       | $            | —     |                               | $          | (387 | ) | $ | 643 |   |

 

The remaining restructuring accrual at April 30, 2004relates to costs associated with one facility that has future lease paymentsextending through June 2005 and payments to be made to employees prior to June30, 2004.

 

**(6)COMMITMENTS AND CONTINGENCIES**

 

**Litigation**

 

*IBM Corporation*

 

On or about March 6, 2003, the Company filed acomplaint against IBM Corporation (“IBM”). The action is currently pending in the United States District Court forthe District of Utah.  The initialcomplaint included claims for breach of contract, misappropriation of tradesecrets, tortious interference, and unfair competition.  The original complaint also alleged that IBMobtained information concerning the UNIX source code and derivative works fromthe Company and inappropriately used and distributed that information inconnection with its efforts to promote the Linux operating system.  As a result of IBM’s actions, the Company isrequesting damages in an amount to be proven at trial, alleged to beapproximately $1 billion, together with additional damages through and afterthe time of trial.  Additionally, on orabout June 13, 2003, the Company delivered to IBM a notice of termination ofIBM’s UNIX license agreement with the Company, which license underlies IBM’sAIX software.

 

On or about June 16,2003, the Company filed an amended complaint in the IBM case.  The amended complaint essentially restatesand realleges the allegations of the original 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 IBM acquired.  The Company alleges its license agreementwith Sequent was breached in several ways similar to those set forth above andit seeks damages flowing from those breaches. The Company also seeks injunctive relief on several of its claims.

 

IBM has filed a response and counterclaim tothe complaint, including a demand for a jury trial.  The Company has filed an answer to the IBMcounterclaim denying the claims and asserting affirmative defenses.  On February 4, 2004, the Company filed amotion for leave to file amended pleadings in the case proposing to amend itscomplaint against IBM and to modify its affirmative defenses against IBM’scounterclaims.  On February 25, 2004, thecourt granted the Company’s motion for leave. The second amended complaint, which was filed on February 27, 2004,alleges nine causes of action that are similar to those set forth above, adds anew claim for copyright infringement and removes the claim for misappropriationof trade secrets.  IBM has

 

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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’scounterclaims include claims for breach of contract, violation of the LanhamAct, unfair competition, intentional interference with prospective economicrelations, unfair and deceptive trade practices, promissory estoppel, copyrightinfringement for a declaratory judgment of non-infringement of copyrights, andpatent infringement.

 

On March 3, 2004, the U.S. Magistrate Judgeissued an order addressing certain discovery matters relating to both theCompany and IBM.  The Company has alsofiled a motion to dismiss IBM’s tenth counterclaim for a declaratory judgmentof non-infringement of copyrights.  TheCompany has also filed a motion to amend the scheduling order and a motion tobifurcate IBM’s patent counterclaims into another action.  The Company filed on May 28, 2004, a publiclyavailable reply brief in connection with its motion to amend the schedulingorder, in which the Company sets forth detailed and specific responses to IBM’sclaims made in connection with that motion. A hearing for these motions was held on June 8, 2004, and the courtissued its ruling on June 10, 2004.  Thecourt granted the Company’s motion to amend the scheduling order, with certainchanges, and denied IBM’s opposition to such an amendment.  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 SCO’s right to raise the issueagain at a later stage.  IBM has alsofiled a motion for partial summary judgment on its tenth counterclaim for adeclaration of non-infringement.  Ahearing regarding our motion to dismiss and IBM’s motion for partial summaryjudgment on IBM’s tenth counterclaim for a declaration of non-infringement iscurrently scheduled for August 4, 2004. Discovery is continuing in the IBM case and the Company plans tovigorously oppose IBM’s motion.

 

*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 interference with prospective businessopportunities, 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

 

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Company’s motion todismiss; however, the court stayed the case. Red Hat has filed a motion for reconsideration.  The Company intends to vigorously defend thisaction.

 

*Novell,Inc.*

 

On or about January 20, 2004, the Company broughtsuit in Utah state court against Novell, Inc. (“Novell”) for slander oftitle seeking relief for Novell’s alleged bad faith efforts to interfere withthe Company’s copyrights related to its UNIX source code and derivative worksand its UnixWare product.  In thelawsuit, the Company requested preliminary and permanent injunctive relief aswell as damages.  Through these claimsthe Company seeks to require Novell to assign to the Company all copyrightsthat it believes Novell has wrongfully registered, prevent Novell fromrepresenting any ownership interest in those copyrights and require Novell toretract or withdraw all representations it has made regarding its purportedownership of those copyrights.  Novellhas not yet answered the Company’s complaint but has filed with the U.S.District Court for the District of Utah a notice removing the case to suchfederal court and a motion with the Third Judicial District Court in Salt LakeCounty, Utah to transfer the venue of the case from such court to the FourthJudicial District Court in Utah County, Utah. 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 plans to continue to vigorouslypursue its claims against Novell.

 

*DaimlerChryslerCorporation*

 

On or around March 3, 2004, the Company brought suitagainst DaimlerChrysler Corporation (“DaimlerChrysler”) for its allegedviolations of its UNIX software agreement with the Company.  Specifically, the lawsuit alleges thatDaimlerChrysler breached its UNIX software agreement with the Company byfailing to certify by January 31, 2004 its compliance with the 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. The Company is in the process of preparing its response toDaimlerChrysler’s motion and the hearing on this motion is set for July 21,2004.

 

*AutoZone,Inc.*

 

On or around March 2, 2004, the Company brought suitagainst AutoZone, Inc. (“AutoZone”) for its alleged violations of the Company’sUNIX copyrights through its use of Linux. Specifically, the lawsuit alleges that AutoZone is infringing theCompany’s UNIX copyrights by,

 

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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.  The Company has filed an opposition to theAutoZone motion and a hearing is scheduled for June 21, 2004 in Nevada.

 

*IPOMatter*

 

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

 

The plaintiffs, the issuers and the insurancecompanies have negotiated a Memorandum of Understanding (“MOU”) with the intentof settling the dispute between the plaintiffs and the issuers.  The Company has executed this MOU and hasbeen advised that almost all (if not all) of the issuers have elected toproceed under the MOU.  The terms of theMOU have been reduced to a settlement agreement that is in the process of beingexecuted by all parties.  This settlementagreement is still subject to court approval. If the settlement is approved by the court, and if no cross-claims,counterclaims or third party claims are later asserted, this action will bedismissed with respect to the Company and its directors.

 

The Company has notified its underwriters andinsurance companies of the existence of the claims.  Management believes, after consultation withlegal counsel, that the ultimate outcome of this matter will not have amaterial adverse effect on the Company’s results of operations or financialposition.  As of April 30, 2004, theCompany has paid or accrued the full retention amount of $200,000under its insurance coverage.

 

*Other Matters*

 

In April 2003, a former Indian distributor of theCompany filed a claim in India, requesting summary judgment for payment of$1,428,000, and an order that the Company trade in India only through thedistributor until the claim is paid.  Thedistributor claims that the Company is responsible to repurchase certainsoftware products and to reimburse the distributor for certain other operatingcosts.  Management does not believe thatthe Company is responsible to reimburse the distributor for any operating costsand also believes that the return rights related to any remaining inventoryhave lapsed.  Management has engagedlocal counsel who has advised that it is likely that the current claims willfail, but that the distributor will continue to pursue its claims either in theIndian courts or in the U.S. courts. Discovery has commenced and initial hearings have been held and areongoing.  The Company intends tovigorously defend this action.

 

Pursuit and defense of the above-mentioned matterswill be costly, and management expects the costs for legal fees and relatedexpenses may be substantial.  Theultimate outcome or

 

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potential effect of theCompany’s results of operations or financial position as a result of theabove-mentioned matters is not currently known or determinable.

 

The Company is a party to certain other legalproceedings arising in the ordinary course of business including legalproceedings arising from its SCOsource initiatives.  Management believes, after consultation with legalcounsel, that the ultimate outcome of such legal proceedings will not have amaterial adverse effect on the Company’s results of operations or financialposition.

 

**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.  These events may include settlements,judgments, licensing fees, subject to certain exceptions, and a sale of theCompany during the pendancy of litigation or through settlement, subject toagreed upon credits for amounts received as discounted hourly fees and unusedretainer fees.  Additionally, the Company’sagreement with the law firms may also be construed to include contingency feepayments in connection with the Company’s issuance of equity securities.  Future payments payable to the law firmsunder this arrangement may be significant.

 

**Redemption Notice from BayStarCapital II, L.P.**

 

OnApril 15, 2004, the Company received a redemption notice from BayStar CapitalII, L.P. (“BayStar”) requesting that the Company immediately redeem 20,000Series A-1 shares then held by BayStar. The redemption notice asserted that BayStar is entitled to redemption ofits shares under the Certificate of Designation, Preferences and Rights of theSeries A-1 because the Company allegedly breached certain provisions of theFebruary 5, 2004 exchange agreement, to which each of the Company and BayStaris a party and pursuant to which all outstanding Series A shares were exchangedfor Series A-1 shares.  BayStar’sredemption notice did not provide specific information regarding the factualbasis for the Company’s alleged breaches and had not been rescinded by April30, 2004.  The Company does not believeit has breached any of the referenced provisions of the exchange agreement,and, as a result, does not believe it is obligated to redeem BayStar’s SeriesA-1 shares.

 

Subsequent to April 30, 2004, as discussed in Note 10,the Company and BayStar entered into an agreement whereby the Company agreed torepurchase and retire all 40,000 Series A-1 shares now owned by BayStar.  This agreement was reached after severaldiscussions between the Company’s management team and Board of Directors andBayStar.  Under the terms of therepurchase agreement, the Company will pay to BayStar $13,000,000 in cash andissue 2,105,263

 

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shares of the Company’scommon stock, which will be payable and issuable upon the effectiveness of ashelf registration statement for the resale of the common stock issued toBayStar.  Upon repurchase, alloutstanding Series A-1 shares will be cancelled and retired and the rights andpreferences of the Series A-1 will be terminated.  The redemption notice has not been rescindedby BayStar.

 

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

 

During the three monthsended April 30, 2004, the Indian branch of the Company’s United Kingdomsubsidiary, SCO Group Ltd., received a withholding tax assessment from theGovernment of India Income Tax Department (“Tax Department”) for the period ofApril 2000 through March 2001.  Duringthe April 2000 through March 2001 period, SCO Group Ltd. was owned by The SantaCruz Operation (now Tarantella, Inc.) and not the Company.  The Company acquired SCO Group Ltd. in May2001 as part of an asset purchase from Tarantella.

 

The Tax Departmentassessed SCO Group Ltd. with a 15 percent withholding tax on certain revenuetransactions in India that the Tax Department deemed royalty revenue under theIndian Income Tax Act.  The total amountof the withholding tax is $396,000.  TheCompany was not aware of this liability until March 2004, when it received aformal tax assessment from the Tax Department, as it believed that it had beenappropriately accounting for the revenue and related taxes on transactions inIndia.

 

The Company has filed an appeal with the TaxDepartment and believes that its packaged software does not qualify for “royalties”treatment, and would therefore not be subject to withholding tax.  Additionally, the SCO Group, Ltd, the companyon which the assessment was levied has filed for bankruptcy.  Although the Company intends to vigorouslydefend this tax assessment, there can be no assurance it will prevail againstthe Tax Department.

 

The Company has recorded the charge for $396,000related to the tax assessment in the three and six months ended April 30, 2004as a component of its provision for income taxes in its statement ofoperations.  In connection with the taxassessment, the Company has accrued $81,000 in penalties that wereassessed.  The Company has also reviewedthe asset purchase agreement between it and Tarantella, specifically theindemnification provision surrounding income taxes.  The Company is in the process of informingTarantella of the existence of this liability and may pursue its options toreceive indemnification from Tarantella for this liability.  At this point, it is unknown if the Companywill be successful in these efforts, and therefore no receivable has been recordedfrom Tarantella.

 

The Company believes that it is probable that the TaxDepartment will pursue similar assessments on SCO Group Ltd. for taxableperiods subsequent to March 2001. Because of this probability, and the Company’s inability to determine atthis point if the Company will prevail against the Tax Department, the Companyhas accrued the full amount of the estimated withholding tax of $314,000 forthese subsequent periods as provision for income taxes in its statements ofoperations for the three and six months ended April 30, 2004.

 

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

 

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

 

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

 

The Company believes that it is reasonably possiblethat some option holders may accept a rescission offer, but the Company is unableto estimate the number of participants who might accept a rescission offer andthe amount of potential damages that it would be required to pay under arescission offer.  Since any loss isconsidered reasonably possible but not estimable, the Company has not recordeda liability for this contingency.

 

The Company may also be required to pay interest andpenalties up to statutory limits in connection with Plan participants makingrescission claims or in connection with any rescission offer.  The Company believes that it is reasonablypossible that it may be required to pay interest and penalties, but it is notable to estimate an amount.

 

**(7)  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 fromthe sale of the Series A were $47,740,000. The value of the Series A is classified outside of permanent equitybecause of certain redemption features that are outside the control of theCompany.

 

The terms of the Series A included a number ofredemption provisions that represent a derivative financial instrument underSFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  The Company determined that the conversionfeature to allow the holders of the Series A to acquire common shares was anembedded derivative that does not qualify as a scope exemption under theprovisions of EITF 00-19, “Accounting for Derivative Financial Instruments Indexedto, and Potentially Settled in a Company’s Own Stock.”  This required the Company to record at fairvalue and mark-to-market the fair value of the derivative.  Changes in

 

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the fair value of thederivative are 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 the derivativewas $11,600,000, and the decrease in fair value of $3,624,000 was recorded aschange in fair value of derivative in other income in the statement ofoperations 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 in a net fair value of$45,065,000.  The difference of$6,305,000 in the fair value of the Series A-1 and the combined carrying valueof the Series A and the related derivative has been recorded as a non-cashdividend in the statements of operations for the three and six months endedApril 30, 2004.

 

Dividends on the Series A-1, if the Series A-1 is notrepurchased by the Company in the repurchase transaction described in more detailin Note 10, will be paid after October 16, 2004, the first anniversary of theoriginal Series A private placement, and will be paid quarterly at a rate of 8percent per annum, subject to annual increases of 2 percent per annum, not toexceed 12 percent per annum.  The Companyhas the option of paying dividends in cash or shares of the Series A-1, subjectto certain limitations.  Becausedividends are not payable during the first year the Series A-1 is outstanding,the Company has accrued dividends of $756,000 for three months ended January31, 2004 and accrued dividends of $740,000 for the three months ended April 30,2004, which reduced earnings to common stockholders.  As of April 30, 2004 accrued dividends were$1,619,000 and were recorded as a component of accrued liabilities.

 

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

 

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

 

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Accounting Series Release (“ASR”) No. 268 and EmergingIssues task Force (“EITF”) Topic D-98 requires that stock subject to rescissionor redemption requirements outside the control of the Company to be classifiedoutside of permanent equity.  The exercise of rescission rights are at theholders’ discretion, but whether they exercise such rights may depend in part onthe fair value of the Company’s common stock, which is outside of the Company’sand the holders’ control. Consequently, common stock subject to rescission is classified astemporary equity.  If the Company’spossible rescission offer is made and accepted by Plan participants holdingshares acquired under the Plans or otherwise entitled to recover damages fromthe Company in respect of such shares they have sold, or such Plan participantsotherwise make rescission claims against the Company, the Company could beliable to make aggregate payments to these Plan participants of up to $231,000in the aggregate, excluding interest and other possible fees, based upon sharesoutstanding under the Plans as of April 30, 2004.

 

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

 

**(9)STOCKHOLDERS’ EQUITY**

 

**Stock-BasedCompensation**

 

The following table details the components ofstock-based compensation for the three and six months ended April 30, 2004 and2003 (in thousands):

 
| ** **                                | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                | ** ** | **(restated)**                   | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Amortization  of stock-based compensation |       | $                                | 113        |                           | $          | 239 |   | $ | 223 |   | $ | 396 |   |
| Options  and shares for services          |       | 50                               |       | 167                            |       | 283 |   | 222 |   |
| Modifications  to options                 |       | —                           |       | —                         |       | 92 |   | — |   |
| Total                                     |       | $                                | 163        |                           | $          | 406 |   | $ | 598 |   | $ | 618 |   |

 

During the three and six months ended April 30, 2004,the Company granted options to purchase 483,000 and 532,000 shares of commonstock with an average exercise price of $8.70 and $9.38 per share,respectively.  None of these stockoptions were granted with an exercise price below the quoted market price onthe date of grant.  During the three andsix months ended April 30, 2004, options to purchase approximately 193,000 and368,000 shares of common stock were exercised with an average exercise price of$1.35 and $1.52 per share, respectively. As of April 30, 2004, there were approximately 3,624,000 stock optionsoutstanding with a weighted average exercise price of $4.48 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.

 

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**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 theCompany.  The agreement is for an initialperiod of three months and may be renewed by both parties for additionalthree-month periods.  The Company willpay the consultant a fixed fee of $10,000 per month.  As part of the agreement, the Company grantedto the consultant an option to acquire 200,000 shares of the Company’s commonstock at a price of $10.03 per share, the fair value of the Company’s commonstock on the date the agreement was finalized. In the event of non-performance by the consultant, the consultant willbe required to pay to the Company a fee equal to 20 percent of the fair valueof the option.  The Company used the Black-Scholesoption pricing model to determine the fair value of the option of $269,000, ofwhich $50,000 was recorded as expense in the three months ended April 30,2004.  Assumptions used in theBlack-Scholes option pricing model to determine the fair value of the optionwere the following; risk free interest rate of 2.9 percent, volatility of 66percent, dividend yield of 0 percent, and a contractual term of three months.

 

In December 2002, the Company issued an option toacquire 50,000 shares of the Company’s common stock at $1.52 per share to aconsultant for services.  The optionsvest upon the achievement of certain milestones.  The fair value of the options is expensed inthe period the milestones are achieved. The final milestone for 15,000 options was achieved during the threemonths ended January 31, 2004 and the Company recorded $233,000 of expenserelated to this option.

 

**StockBuyback Program**

 

On March 10, 2004, theCompany’s board of directors authorized management, in its discretion, topurchase up to 1,500,000 shares of the Company’s common stock over the 24-monthperiod following March 10, 2004, the time at which the repurchase program waseffective.  Any repurchased shares willbe held in treasury and will be available for general corporate purposes.  The repurchase program will allow the Companyto repurchase its shares from time to time in accordance with the requirementsof the Securities and Exchange Commission on the open market, in block tradesand in privately negotiated transactions, depending on market conditions andother factors.  During the three monthsended April 30, 2004, the Company purchased approximately 290,000 shares of itscommon stock at a total cost of approximately $2,414,000.

 

**(10)SIGNIFICANT CUSTOMERS**

 

During the three and six months ended April 30, 2004and 2003, no single customer accounted for more than 10 percent of totalrevenue.

 

**(11)SEGMENT INFORMATION**

 

The Company’s resources are allocated and operatingresults managed to the operating income (loss) level for each of the Company’stwo geographic units for its UNIX division and the Company’s SCOsourcelicensing division.  The geographic unitsfor the UNIX division consist of the Americas division and the Internationaldivision.  The revenue, cost of revenueand direct sales and marketing expenses are tracked for each division.  The costs of corporate sales and marketing,research and development, general and administration and other (which includenon-cash

 

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amortization ofintangibles assets related to the UNIX division) are allocated to each divisionbased on that division’s percentage of total revenue.  The corporate revenue and expenses includeamounts not directly attributable to a specific division.

 

For purposes of comparing the three and six monthperiods ended April 30, 2003 to the three and six month periods ended April 30,2004, the Company has combined the results of operations for its EMEA and Asiaoperations into the column ‘International’, has segregated its SCOsourceoperations from the ‘Corporate’ column, and has also allocated the amortizationof intangible assets to the Americas and International divisions.

 

Segment disclosures for the Company’s operatingdivisions are as follows for the three and six months ended April 30, 2004 and2003 (in thousands):

 
| ** **                     | ** ** | **Three Months Ended April 30, 2004 (restated)** | ** ** |
|--------------------------------|------------|--------------------------------------------------|------------|
| ** **                     | ** ** | **Americas**                                     | ** ** | **International** | ** ** | **SCOsource** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                           |       |                                             |       |   |   |   |   |   |   |   |   |
| Revenue                        |       | $                                                | 5,807      |   | $ | 4,206 |   | $ | 11 |   | $ | 113 |   | $ | 10,137 |   |
| Cost  of revenue               |       | 1,228                                            |       | 732 |   | 4,484 |   | 14 |   | 6,458 |   |
| Gross  margin                  |       | 4,579                                            |       | 3,474 |   | (4,473 | ) | 99 |   | 3,679 |   |
| Sales  and marketing           |       | 1,687                                            |       | 2,430 |   | 581 |   | — |   | 4,698 |   |
| Research  and development      |       | 1,622                                            |       | 1,175 |   | 71 |   | — |   | 2,868 |   |
| General  and administrative    |       | 1,387                                            |       | 1,005 |   | — |   | — |   | 2,392 |   |
| Other                          |       | 344                                              |       | 249 |   | — |   | 2,302 |   | 2,895 |   |
| Total  operating expenses      |       | 5,040                                            |       | 4,859 |   | 652 |   | 2,302 |   | 12,853 |   |
| Loss  from operations          |       | $                                                | (461       | ) | $ | (1,385 | ) | $ | (5,125 | ) | $ | (2,203 | ) | $ | (9,174 | ) |
|                           |       |                                             |       |   |   |   |   |   |   |   |   |
| ** **                     | ** ** | **Three Months Ended April 30, 2003**            | ** ** |
| ** **                     | ** ** | **Americas**                                     | ** ** | **International** | ** ** | **SCOsource** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                           |       |                                             |       |   |   |   |   |   |   |   |   |
| Revenue                        |       | $                                                | 6,710      |   | $ | 6,335 |   | $ | 8,250 |   | $ | 74 |   | $ | 21,369 |   |
| Cost  of revenue               |       | 1,357                                            |       | 1,254 |   | 2,163 |   | 373 |   | 5,147 |   |
| Gross  margin                  |       | 5,353                                            |       | 5,081 |   | 6,087 |   | (299 | ) | 16,222 |   |
| Sales  and marketing           |       | 2,375                                            |       | 3,670 |   | — |   | 6 |   | 6,051 |   |
| Research  and development      |       | 1,300                                            |       | 1,228 |   | — |   | 14 |   | 2,542 |   |
| General  and administrative    |       | 748                                              |       | 706 |   | — |   | 8 |   | 1,462 |   |
| Other                          |       | 357                                              |       | 343 |   | — |   | 542 |   | 1,242 |   |
| Total  operating expenses      |       | 4,780                                            |       | 5,947 |   | — |   | 570 |   | 11,297 |   |
| Income  (loss) from operations |       | $                                                | 573        |   | $ | (866 | ) | $ | 6,087 |   | $ | (869 | ) | $ | 4,925 |   |

 

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| ** **                     | ** ** | **Six Months Ended April 30, 2004**  | ** ** |
|--------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **Americas**                         | ** ** | **International** | ** ** | **SCOsource** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                           |       |                                 |       |   |   |   |   |   |   |   |   |
| Revenue                        |       | $                                    | 12,570     |   | $ | 8,879 |   | $ | 31 |   | $ | 49 |   | $ | 21,529 |   |
| Cost  of revenue               |       | 2,598                                |       | 1,550 |   | 7,924 |   | 36 |   | 12,108 |   |
| Gross  margin                  |       | 9,972                                |       | 7,329 |   | (7,893 | ) | 13 |   | 9,421 |   |
| Sales  and marketing           |       | 4,230                                |       | 4,898 |   | 591 |   | — |   | 9,719 |   |
| Research  and development      |       | 3,219                                |       | 2,258 |   | 98 |   | — |   | 5,575 |   |
| General  and administrative    |       | 2,681                                |       | 1,883 |   | 22 |   | — |   | 4,586 |   |
| Other                          |       | 816                                  |       | 564 |   | — |   | 2,737 |   | 4,117 |   |
| Total  operating expenses      |       | 10,946                               |       | 9,603 |   | 711 |   | 2,737 |   | 23,997 |   |
| Loss  from operations          |       | $                                    | (974       | ) | $ | (2,274 | ) | $ | (8,604 | ) | $ | (2,724 | ) | $ | (14,576 | ) |
|                           |       |                                 |       |   |   |   |   |   |   |   |   |
| ** **                     | ** ** | **Six Months Ended April  30, 2003** | ** ** |
| ** **                     | ** ** | **Americas**                         | ** ** | **International** | ** ** | **SCOsource** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                           |       |                                 |       |   |   |   |   |   |   |   |   |
| Revenue                        |       | $                                    | 13,974     |   | $ | 12,525 |   | $ | 8,250 |   | $ | 160 |   | $ | 34,909 |   |
| Cost  of revenue               |       | 2,716                                |       | 2,659 |   | 2,163 |   | 487 |   | 8,025 |   |
| Gross  margin                  |       | 11,258                               |       | 9,866 |   | 6,087 |   | (327 | ) | 26,884 |   |
| Sales  and marketing           |       | 5,010                                |       | 7,471 |   | — |   | 10 |   | 12,491 |   |
| Research  and development      |       | 2,722                                |       | 2,439 |   | — |   | 31 |   | 5,192 |   |
| General  and administrative    |       | 1,633                                |       | 1,460 |   | — |   | 19 |   | 3,112 |   |
| Other                          |       | 742                                  |       | 658 |   | — |   | 502 |   | 1,902 |   |
| Total  operating expenses      |       | 10,107                               |       | 12,028 |   | — |   | 562 |   | 22,697 |   |
| Income  (loss) from operations |       | $                                    | 1,151      |   | $ | (2,162 | ) | $ | 6,087 |   | $ | (889 | ) | $ | 4,187 |   |

 

Long-lived assets, which include property andequipment as well as intangible assets and goodwill, by location consist of thefollowing as of April 30, 2004 and October 31, 2003 (in thousands):

 
| ** **               | ** ** | **April 30,  2004** | ** ** | **October 31,  2003** | ** ** |
|--------------------------|------------|---------------------|------------|-----------------------|------------|
| Long-lived  assets:      |       |                |       |                  |       |
| United  States           |       | $                   | 7,357      |                  | $          | 11,234 |   |
| International            |       | 282                 |       | 366                   |       |
| Total  long-lived assets |       | $                   | 7,639      |                  | $          | 11,600 |   |

 

**(12) SUBSEQUENT EVENTS**

 

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

 

On May 5, 2004, the Company received anotice from Royal Bank of Canada (“RBC”) that RBC had elected to convert 10,000Series A-1 shares into a total of 740,740 shares of the

 

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Company’s common stock.  The converted Series A-1 shares wereoriginally purchased at a price of $1,000 per share and were converted intoshares of common stock based on a conversion price of $13.50 per share.  Additionally, RBC informed the Company thatit sold its remaining 20,000 Series A-1 shares to BayStar, which now holds atotal of 40,000 Series A-1 shares.

 

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

 

On May 31, 2004, theCompany entered into an agreement with BayStar to repurchase and retire BayStar’s40,000 Series A-1 shares.  Terms of theagreement require the Company to pay to BayStar $13,000,000 in cash and issue2,105,263 shares of the Company’s common stock. The repurchase price will be payable and issuable upon the effectivenessof a shelf registration statement for the resale of the shares of common stockthat will be issued to BayStar upon the completion of the repurchase.  In the event that a shelf registrationstatement is not declared effective by the SEC, the transaction will not becompleted.  Upon repurchase, all SeriesA-1 shares will be cancelled and retired and the rights and preferences of theSeries A-1 and associated contractual rights will be terminated.

 

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**ITEM 2.****                 MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*This Management’s Discussion and Analysis ofFinancial Condition and Results of Operations and other parts of this quarterlyreport on Amendment No. 1 to Form 10-Q/A contain forward-looking statementsthat involve risks and uncertainties. Forward-looking statements can also be identified by words such as “intends,”“anticipates,” “expects,” “believes,” “plans,” “predicts,” and similarterms.  Forward-looking statements arenot guarantees of future performance and our actual results may differsignificantly from the results discussed in the forward-looking statements.  Factors that might cause such differencesinclude, but are not limited to, those set forth below under “Forward-LookingStatements” and “Risk Factors” and elsewhere in this Amendment No. 1 to Form10-Q/A. The following discussion should be read in conjunction with our consolidatedfinancial statements and notes thereto included in this Amendment No. 1 to Form10-Q/A and our annual report on Form 10-K for the year ended October 31, 2003filed with the Securities and Exchange Commission, including the auditedfinancial statements and management’s discussion and analysis containedtherein.  All information presentedherein is based on the three and six months ended April 30, 2004.  We assume no obligation to revise or updateany forward-looking statements for any reason, except as required by law.*

 

**Restatement of Financial Statements**

 

As discussed in Note 2 to the Financial Statements,the Company’s condensed consolidated financial statements as of and for thethree and six months ended April 30, 2004 have been restated.  The accompanying management’s discussion andanalysis gives effect to that restatement.

 

**Overview**

 

*Historical Background. *We originally incorporatedas Caldera Systems, Inc., a Utah corporation (“Caldera Systems”), andreincorporated as a Delaware corporation on March 6, 2000.  In March 2000, we completed an initial publicoffering of our common stock.  On May 7, 2001, we formed a new holdingcompany in Delaware under the name of Caldera International, Inc. to acquiresubstantially all of the assets and operations of the server and professionalservices groups of The Santa Cruz Operation (now Tarantella, Inc.).  In connection with this acquisition, CalderaSystems became a wholly-owned subsidiary of Caldera International, Inc.  Former holders of shares and optionsto purchase shares of Caldera Systems received an equal number of shares andoptions to purchase shares in CalderaInternational, Inc.  On May 16, 2003, our stockholders approvedour corporate name change to The SCO Group, Inc.

 

*RecentDevelopments.*  On February 5, 2004, we completed atransaction pursuant to an exchange agreement among us, BayStar Capital II, L.P. (“BayStar”) and Royal Bank of Canada (“RBC”) inwhich each outstanding share of our then-outstanding redeemable Series AConvertible Preferred Stock was exchanged for one share of our new redeemableSeries A-1 Convertible Preferred Stock.  On April 15, 2004, we received a redemptionnotice from BayStar requesting that we immediately redeem 20,000 Series A-1shares then held by BayStar.  The redemptionnotice asserted that BayStar is entitled to redemption of its the Series A-1shares under the Certificate of Designation, Preferences and Rights for theSeries A-1 shares because we allegedly had breached certain provisions of ourFebruary 5, 2004 exchange agreement. BayStar’s redemption notice did not provide specific informationregarding the factual basis for our alleged breaches of the exchange agreement,but we do not believe we have breached the exchange agreement.  As a result, we do not believe we areobligated to redeem BayStar’s Series A-1 shares.

 

On May 5, 2004, we received a notice from RBC of its election to convert10,000 shares of our Series A-1 Convertible Preferred Stock into a total of740,740 shares of our common stock.

 

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Additionally, RBC informed us that it soldits remaining 20,000 Series A-1 shares to BayStar, making BayStar the soleholder of all 40,000 outstanding Series A-1 shares.

 

On May 31, 2004, weentered into an agreement with BayStar to repurchase and retire BayStar’s40,000 Series A-1 shares.  Terms of theagreement require us to pay to BayStar $13,000,000 in cash and issue 2,105,263shares of our common stock, which consideration will be payable and issuableupon the effectiveness of a registration statement covering the resale of thecommon stock issued to BayStar.  In theevent that the registration statement is not declared effective by the SEC, therepurchase transaction with BayStar will not be completed.  Upon completion of the repurchasetransaction, all Series A-1 shares will be cancelled and retired and the rightsand preferences of the Series A-1 shares will be terminated.  The transaction will also eliminate BayStar’scontractual rights and will include a general release by both parties.

 

On or about January20, 2004, we brought suit against Novell, Inc. (“Novell”) for slanderof title seeking relief for Novell’s alleged bad faith efforts to interferewith our copyrights related to our UNIX source code and derivative works andour UnixWare product.  In the lawsuit, 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.

 

On or about March 2,2004, we brought suit against AutoZone, Inc. for its alleged violations of ourUNIX copyrights through its use of Linux. Specifically, the lawsuit alleges that AutoZone is infringing our UNIXcopyrights by, among other things, running versions of the Linux operatingsystem that contain code, structure, sequence and/or organization from ourproprietary UNIX System V code in violation of our copyrights.  The lawsuit filed in U.S. District Court inNevada requests injunctive relief against AutoZone’s further use or copying ofany part of our copyrighted materials and also requests damages as a result ofAutoZone’s infringement 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.  We have filed an opposition to the AutoZonemotion and a hearing is currently scheduled for June 21, 2004.

 

On or about March 3, 2004, we brought suit againstDaimlerChrysler Corporation for its alleged violations of its UNIX softwareagreement with us.  Specifically, thelawsuit alleges that DaimlerChrysler breached its UNIX software agreement withus by failing to voluntarily certify by January 31, 2004 its compliance withits UNIX software agreement as required by us. 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 us damages in amountto be determined at trial together with costs, attorneys’ fees and any suchother or different relief that the Court may deem to be equitable andjust.  On April 15, 2004, DaimlerChryslerfiled a motion to dismiss our claims.  Weare in the process of preparing our response to DaimlerChrysler’s motion andthe hearing on this motion is set for July 21, 2004.

 

On March 10, 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.

 

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Any repurchased shareswill be held as treasury stock and will be available for general corporatepurposes.  During the quarter ended April30, 2004, we purchased 290,000 shares of our common stock in open marketpurchases for a total cost of $2,414,000.

 

**BusinessFocus**

 

We generate revenueprimarily from two sources: product and services revenue from our UNIXoperating systems business and license fees from our SCOsource licensingbusiness.

 

*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 our worldwide,indirect, leveraged channel of partners, which includes distributors andindependent solution providers.  We havelocal offices in a number of countries that provide support and services tocustomers and resellers in that geographic area.  The other principal channel for selling andmarketing our UNIX products is through major corporations that have a largenumber of replicated sites or franchisees. We access these corporations through their information technology orpurchasing departments with our Area Sales Managers in the United States andthrough our reseller channel in countries outside the United States.  In addition, we also sell our operatingsystem products to OEMs.  Until fiscalyear 2003, the majority of our revenue and our operating expenses were derivedfrom our UNIX business.  The followingtable shows the operating results of the UNIX business (excluding the SCOsourcedivision and corporate costs) for the three and six months ended April 30, 2004and 2003 (in thousands):

 
| ** **                  | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                        |       |                             |       |                           |       |   |   |   |   |
| Revenue                     |       | $                                | 10,013     |                           | $          | 13,045 |   | $ | 21,449 |   | $ | 26,499 |   |
| Cost  of revenue            |       | 1,960                            |       | 2,611                          |       | 4,148 |   | 5,375 |   |
| Gross  margin               |       | 8,053                            |       | 10,434                         |       | 17,301 |   | 21,124 |   |
| Sales  and marketing        |       | 4,117                            |       | 6,045                          |       | 9,128 |   | 12,481 |   |
| Research  and development   |       | 2,797                            |       | 2,528                          |       | 5,477 |   | 5,161 |   |
| General  and administrative |       | 2,392                            |       | 1,454                          |       | 4,564 |   | 3,093 |   |
| Other                       |       | 593                              |       | 700                            |       | 1,380 |   | 1,400 |   |
| Total  operating expenses   |       | 9,899                            |       | 10,727                         |       | 20,549 |   | 22,135 |   |
| Loss  from operations       |       | $                                | (1,846     | )                              | $          | (293 | ) | $ | (3,248 | ) | $ | (1,011 | ) |

 

Revenue from ourUNIX business decreased by $3,032,000, or 23 percent, for the second quarter offiscal year 2004 compared to the second quarter of fiscal year 2003, andrevenue from our UNIX business decreased by $5,050,000, or 19 percent, for thefirst two quarters of fiscal year 2003 compared to the first two quarters offiscal year 2004.  The revenue from thisbusiness has been declining over the last several quarters primarily as aresult of increased competition from alternative operating systems,particularly Linux, and lower information technology spending for UNIXproducts.  If we are unable to generatepositive cash flow and profitable operations, our UNIX operations may be adverselyimpacted.

 

The decline in our UNIXbusiness revenue may be accelerated if industry partners withdraw their supportas a result of our SCOsource initiatives and in particular any lawsuits againstend users violating our intellectual property and contractual rights.  Our SCOsource initiatives, particularlylawsuits against such end users, may cause industry partners, developers andhardware and software vendors to choose not to support or certify to our UNIXoperating

 

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system products.  This would lead to an accelerated decline inour UNIX products and services revenue.

 

In an effort to attainprofitability in our UNIX division, we have decreased our operating costs andincreased our gross margin percentage over the last several quarters.  Operating costs for our UNIX divisiondecreased from $10,727,000 for the second quarter of fiscal year 2003 to$9,899,000 for the second quarter of fiscal year 2004, and decreased from$22,135,000 for the first two quarters of fiscal year 2003 to $20,549,000 forthe first two quarters of fiscal year 2004. These cost reductions have primarily been attributable to reducedheadcount.  We have reduced the number ofemployees in our UNIX division from 329 as of April 30, 2003 to 263 as of April30, 2004, eliminated redundant facilities and reduced other discretionaryspending while still preserving our worldwide infrastructure.  Our gross margin percentage from our UNIXbusiness during these periods was consistently near 80 percent.

 

Included in operating costsin the above table, under the caption ‘Other,’ are non-cash charges for theamortization of intangibles.  Also duringthe second quarter of fiscal year 2004, we incurred a charge of $682,000classified as general and administrative expense that was related to theelimination of certain positions in the UNIX division.  We believe that these cuts will enable theUNIX division to generate improved operating results for the last two quartersof fiscal year 2004.

 

An important initiative forour UNIX division for our 2004 fiscal year will be our continued investment inand commitment to our UNIX operating systems. As part of this initiative, we intend to release new versions of our UnixWareoperating system in June 2004 and our OpenServer operating system in the firstcalendar quarter of 2005 and will provide these products with increased systemreliability, backward compatibility with existing applications and software,increased application and hardware support, integrate 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, we became aware that our UNIX code andderivative works had been inappropriately included in the Linux operatingsystem.  We believe the inclusion of ourUNIX code and derivative works in Linux has been a major contributor to thedecline in our UNIX business because users of Linux generally do not pay forthe operating system but only minimal fees, if any, for service andmaintenance.  The Linux operating systemcompetes directly with our OpenServer and UnixWare products and has takensignificant market share from these products.

 

In an effort to protect our UNIX intellectualproperty, we initiated our SCOsource licensing initiatives.  These initiatives now include, among others,seeking to enter into license agreements with UNIX vendors and implementing aworldwide program offering SCOsource intellectual property (“IP”) licenses toLinux end users allowing them to continue to use our UNIX source code andderivative works found in Linux.  OurSCOsource efforts resulted in the execution of two significant vendor licenseagreements during fiscal year 2003.  Inthe second quarter of fiscal year 2004, we increased our SCOsource sales andmarketing efforts as we continue to implement our SCOsource licensingstrategies.

 

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Thefollowing table shows the operating results of the SCOsource business for thethree and six months ended April 30, 2004 and 2003 (in thousands):

 
| ** **                    | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|-------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                          |       |                             |       |                           |       |   |   |   |   |
| Revenue                       |       | $                                | 11         |                           | $          | 8,250 |   | $ | 31 |   | $ | 8,250 |   |
| Cost of revenue               |       | 4,484                            |       | 2,163                          |       | 7,924 |   | 2,163 |   |
| Gross margin                  |       | (4,473                           | )          | 6,087                          |       | (7,893 | ) | 6,087 |   |
| Sales and marketing           |       | 581                              |       | —                         |       | 591 |   | — |   |
| Research and development      |       | 71                               |       | —                         |       | 98 |   | — |   |
| General and administrative    |       | —                           |       | —                         |       | 22 |   | — |   |
| Other                         |       | —                           |       | —                         |       | — |   | — |   |
| Total operating expenses      |       | 652                              |       | —                         |       | 711 |   | — |   |
| Income (loss) from operations |       | $                                | (5,125     | )                              | $          | 6,087 |   | $ | (8,604 | ) | $ | 6,087 |   |

 

Ourfuture success 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, and we generally expect quarterly legalfees and other SCOsource related costs for the last two quarters of fiscal year2004 will be consistent with the current level of costs incurred in the secondquarter of fiscal year 2004. However, legalexpenses could increase over time depending on developments in our litigationmatters, and certain events may take place that could require us to pay a 20percent contingency fee to our law firms. These events may include settlements,judgments, licensing fees, subject to certain exceptions, and a sale of ourcompany during the pendancy of litigation or through settlement, subject toagreed upon credits for amounts received as discounted hourly fees and unusedretainer fees. Additionally, our agreement with our law firms may also beconstrued to include contingency fee payments in connection with any issuanceof our equity securities.

 

Because of theuncertainties related to our SCOsource business, we are unable to estimate theamount and timing of future SCOsource licensing revenue. This uncertaintyrepresents a significant risk and challenge for us, both in the short and longterm. If we do receive revenue from this source, it may be sporadic andfluctuate from quarter to quarter. Our SCOsource initiatives are unlikely toproduce a stable or predictable revenue stream for the foreseeable future.Additionally, the success of these initiatives may depend on the strength ofour intellectual property rights and contractual claims regarding UNIX,including the strength of our claim that unauthorized UNIX source code andderivative works are prevalent in Linux. We generated minimal SCOsource revenuein the first and second quarters of fiscal year 2004, but we anticipate thatrevenue from vendor licenses and IP licenses will increase during the last twoquarters of fiscal year 2004.

 

**CriticalAccounting Policies**

 

Our criticalaccounting policies and estimates include the following:

 

•                                          Revenue recognition;

 

•                                          Deferred income taxes and relatedvaluation allowances;

 

•                                          Fair value of derivative financialinstrument and Series A-1 Convertible Preferred Stock;

 

•                                          Impairment of long-lived assets; and

 

•                                          Allowances for doubtful accounts.

 

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*RevenueRecognition*. We recognize revenuein accordance with Statement of Accounting Position (“SOP”) 97-2, as amended,and Staff Accounting Bulletin (“SAB”) 104. Revenue recognition in accordancewith these pronouncements can be complex due to the nature and variability ofour sales transactions. We recognize products revenue and SCOsource revenueupon shipment if a signed contract exists, the fee is fixed and determinable,collection of the resulting receivable is probable and product returns arereasonably estimable, except for sales to distributors, which are recognizedupon sale by the distributor to end users. We recognize product revenue fromroyalty payments upon receipt of quarterly royalty reports from OEMs related totheir product sales.

 

The majority of ourrevenue transactions relate to product sales only. On occasion we have revenuetransactions that include multiple elements (i.e., delivered and undeliveredelements including maintenance, support and other services). For invoices orcontracts involving multiple elements, we allocate revenue to each component ofthe contract based on objective evidence of its fair value. The fair value ofeach element is based on amounts charged when such elements are sold inseparate transactions. We recognize revenue allocated to undelivered productswhen the criteria for revenue recognition set forth above have been met.

 

Estimates used in ourrevenue recognition include the determination of credit-worthiness andverification of sales-out reporting to end users through our two-tierdistribution channel. We also provide reserves against revenue based onhistorical trends and experience. To the extent these estimates were incorrectour recognized revenue would be adversely impacted and would harm our resultsof operations. Additionally, if our business conditions change or our revenuecontracts begin to contain more multiple elements, our future revenuerecognition in future periods may be impacted as a larger component of revenuemay be deferred. As of April 30, 2004, our deferred revenue balance was$7,554,000 and related primarily to product maintenance and support contracts.

 

*DeferredIncome Taxes and Related Valuation Allowance*.The amount, and ultimate realization, of our deferred income tax assetsdepends, in part, upon the tax laws in effect, our future earnings and otherfuture events, the effects of which cannot be determined. We have provided avaluation allowance of $52,908,000 against our entire net deferred tax asset asof October 31, 2003. The valuation allowance was recorded because of ourhistory of net operating losses and the uncertainties regarding our futureoperating profitability and taxable income.

 

*FairValue of Derivative Financial Instrument and Series A-1 Convertible PreferredStock*. On October 16, 2003,we issued 50,000 shares of our redeemable Series A Convertible Preferred Stockfor $1,000 per share.  The net proceedsfrom the sale of the preferred stock were $47,740,000.  The terms of the preferred stock includeconversion and a number of redemption provisions that represent a derivativefinancial instrument under SFAS No. 133, “Accounting for Derivative Instrumentsand Hedging Activities,” as amended.  Wedetermined that the conversion feature allowing the holders of the preferredstock to acquire common shares is an embedded derivative financial instrumentthat does not qualify as a scope exemption under the provisions of EmergingIssues Task Force (“EITF”) 00-19, “Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in a Company’s Own Stock.”

 

As of October 16, 2003,through the assistance of an independent valuation firm, we determined theinitial fair value of the derivative was $18,069,000 and the value of thepreferred stock was $29,671,000.  We wererequired to account for the conversion feature as an embedded derivative sincethe preferred stock instrument did not entitle the holders to equity featuressuch as voting rights and board representation. 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, thefair value of the derivative was $11,600,000 and the decrease in fair value of$3,624,000

 

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was recorded as change in fair value ofderivative in other income in our condensed consolidated statement ofoperations for the three months ended January 31, 2004.

 

On February 5,2004, we completed an exchange transaction in which each outstanding Series Ashare was exchanged for one share of our new redeemable Series A-1 ConvertiblePreferred Stock.  We received noadditional proceeds in the exchange.  Theexchange transaction eliminated the derivative related to the Series A sharesthat was initially recorded as a current liability on our balance sheet andeliminated the charge in our quarterly statements of operations for the changein the fair value of the derivative related to the Series A shares.  The derivative was eliminated due to certainrights and privileges included in the new Series A-1 shares, such as votingrights and rights to board representation, among others, that were not includedin the Series A shares.

 

We recorded $2,300,000as change in fair value of derivative in other income in the second quarter offiscal year 2004 related to the change in the fair value of the derivativebetween January 31, 2004 and February 5, 2004, the time at which the exchangeagreement was executed.  Through theassistance of an independent valuation firm, we determined the fair value ofthe Series A-1 shares to be $45,276,000 as of February 5, 2004.  We recorded a dividend in the second quarterof fiscal year 2004 of $6,305,000 related 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, 2004 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.

 

*Impairmentof Long-lived Assets*.  We review our long-lived assets forimpairment when events or changes in circumstances indicate that the book valueof an asset may not be recoverable.  Weevaluate, at each balance sheet date, whether events and circumstances haveoccurred which indicate possible impairment. The carrying value of a long-lived asset is considered impaired when theanticipated cumulative undiscounted cash flows of the related asset or group ofassets is less than the carrying value. In that event, a loss is recognized based on the amount by which thecarrying value exceeds the estimated fair market value of the long-lived asset.

 

We performed animpairment analysis as of April 30, 2004 in accordance with SFAS No. 142, “Goodwilland Other Intangible Assets”  and SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” anddetermined that the goodwill and intangible assets related to the Vultustechnology, which we acquired from Vultus, Inc. (“Vultus”) in June 2003, hadbeen impaired.  We concluded that animpairment-triggering event occurred during the second quarter of fiscal year2004 as an impending partnership that would solidify the Vultus revenue andcash flow opportunities did not materialize. Additionally, we had a reduction in force that impacted our ability tomove the Vultus initiative forward on a stand-alone basis.  Consequently, we have concluded that nosignificant future cash flows related to its Vultus assets would berealized.  As a result of these analyses,we wrote-down the carrying value of our goodwill related to the Vultusacquisition from $1,166,000 to $0 and wrote-down intangible assets related toour Vultus acquisition from $973,000 to $0.

 

Write-downs ofintangible assets may be necessary if the future fair value of these assets isless than carrying value.  If theoperating trends for our UNIX business continue to decline or the value of ourcommon stock were to significantly decrease, we may be required to record animpairment charge in a future period related to the carrying value of ourintangible assets with finite lives.

 

*Allowancefor Doubtful Accounts*.  We offer credit terms on thesale of our products to a majority of our customers and require no collateralfrom these customers.  We perform ongoing

 

34

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credit evaluations ofour customers’ financial condition and maintain an allowance for doubtfulaccounts based upon our historical collection experience and expectedcollectibility of all accounts receivable and have applied these policiesconsistently throughout the three and six months ended April 30, 2004.  Our allowance for doubtful accounts, which isdetermined based on our historical experience and a specific review of customerbalances, was $155,000 as of April 30, 2004. Our past experience has resulted in minimal differences from the actualamounts provided for bad debts and our recorded estimates.  However, our actual bad debts in futureperiods may differ from our current estimates and the differences may bematerial, which may have an adverseimpact on our future accounts receivable and cash position.

 

**Results of Operations**

 

The following table presentsour results of operations for the three and six months ended April 30, 2004 and2003 (in thousands):

 

**Statement of Operations Data:**

 
| ** **                                           | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| * *                                             |       | **(restated)**                   |       |                           |       |   |   |   |   |
| Revenue:                                             |       |                             |       |                           |       |   |   |   |   |
| Products                                             |       | $                                | 8,415      |                           | $          | 11,122 |   | $ | 18,127 |   | $ | 22,212 |   |
| SCOsource licensing                                  |       | 11                               |       | 8,250                          |       | 31 |   | 8,250 |   |
| Services                                             |       | 1,711                            |       | 1,997                          |       | 3,371 |   | 4,447 |   |
| Total revenue                                        |       | 10,137                           |       | 21,369                         |       | 21,529 |   | 34,909 |   |
| Cost of revenue:                                     |       |                             |       |                           |       |   |   |   |   |
| Products                                             |       | 901                              |       | 1,206                          |       | 1,789 |   | 2,392 |   |
| SCOsource licensing                                  |       | 4,484                            |       | 2,163                          |       | 7,924 |   | 2,163 |   |
| Services                                             |       | 1,073                            |       | 1,778                          |       | 2,395 |   | 3,470 |   |
| Total cost of revenue                                |       | 6,458                            |       | 5,147                          |       | 12,108 |   | 8,025 |   |
| Gross margin                                         |       | 3,679                            |       | 16,222                         |       | 9,421 |   | 26,884 |   |
| Operating expenses:                                  |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                                  |       | 4,698                            |       | 6,051                          |       | 9,719 |   | 12,491 |   |
| Research and development                             |       | 2,868                            |       | 2,542                          |       | 5,575 |   | 5,192 |   |
| General and administrative                           |       | 2,392                            |       | 1,462                          |       | 4,586 |   | 3,112 |   |
| Loss on impairment of long-lived assets              |       | 2,139                            |       | —                         |       | 2,139 |   | — |   |
| Restructuring charges (reversals)                    |       | —                           |       | 136                            |       | — |   | (116 | ) |
| Amortization of intangibles                          |       | 593                              |       | 700                            |       | 1,380 |   | 1,400 |   |
| Stock-based compensation                             |       | 163                              |       | 406                            |       | 598 |   | 618 |   |
| Total operating expenses                             |       | 12,853                           |       | 11,297                         |       | 23,997 |   | 22,697 |   |
| Income (loss) from operations                        |       | (9,174                           | )          | 4,925                          |       | (14,576 | ) | 4,187 |   |
| Equity in income (losses) of affiliates              |       | 37                               |       | (75                            | )          | 74 |   | (100 | ) |
| Other income (expense), net                          |       | 2,422                            |       | (48                            | )          | 6,185 |   | (4 | ) |
| Provision for income taxes                           |       | (966                             | )          | (302                           | )          | (1,094 | ) | (307 | ) |
| Net income (loss)                                    |       | (7,681                           | )          | 4,500                          |       | (9,411 | ) | 3,776 |   |
| Dividends on redeemable convertible  preferred stock |       | (7,045                           | )          | —                         |       | (7,801 | ) | — |   |
| Net income (loss) applicable to common  stockholders |       | $                                | (14,726    | )                              | $          | 4,500 |   | $ | (17,212 | ) | $ | 3,776 |   |
|                                                      |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |

 

35

----

 

**THREEAND SIX MONTHS ENDED APRIL 30, 2004 AND 2003**

 

### ***Revenue***

 
| ** ** | ** ** | **Three Months Ended April 30,** | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|       |       |                             |       |   |   |   |   |
| Revenue    |       | $                                | 10,137,000 |   | (53 | )% | $ | 21,369,000 |   |
|            |            |                                  |            |  |  |  |  |  |  |

 
| ** ** | ** ** | **Six Months Ended April 30,** | ** ** |
|------------|------------|--------------------------------|------------|
| ** ** | ** ** | **2004**                       | ** ** | **Change** | ** ** | **2003** | ** ** |
|       |       |                           |       |   |   |   |   |
| Revenue    |       | $                              | 21,529,000 |   | (38 | )% | $ | 34,909,000 |   |
|            |            |                                |            |  |  |  |  |  |  |

 

Revenuefor the second quarter of fiscal year 2004 decreased by $11,232,000, or 53percent, from the second quarter of fiscal year 2003, and revenue for the firsttwo quarters of fiscal year 2004 decreased by $13,380,000, or 38 percent, fromthe first two 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 secondquarter of fiscal year 2004 compared to SCOsource revenue of $8,250,000 in thesecond quarter of fiscal year 2003.

 

Revenuegenerated from our UNIX operating divisions (Americas and International),SCOsource division and other was as follows:

 
| ** **               | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                     |       |                             |       |   |   |   |   |
| Americas revenue         |       | $                                | 5,807,000  |   | (13 | )% | $ | 6,710,000 |   |
| Percent of total revenue |       | 57                               | %          |   |   | 31 | % |
| International revenue    |       | 4,206,000                        |       | (34 | )% | 6,335,000 |   |
| Percent of total revenue |       | 42                               | %          |   |   | 30 | % |
| SCOsource revenue        |       | 11,000                           |       | (100 | )% | 8,250,000 |   |
| Percent of total revenue |       | 0                                | %          |   |   | 39 | % |
| Other revenue            |       | 113,000                          |       | 53 | % | 74,000 |   |
| Percent of total revenue |       | 1                                | %          |   |   | 0 | % |
|                          |            |                                  |            |  |  |  |  |  |  |

 
| ** **               | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **2004**                       | ** ** | **Change** | ** ** | **2003** | ** ** |
|                     |       |                           |       |   |   |   |   |
| Americas revenue         |       | $                              | 12,570,000 |   | (10 | )% | $ | 13,974,000 |   |
| Percent of total revenue |       | 58                             | %          |   |   | 40 | % |
| International revenue    |       | 8,879,000                      |       | (29 | )% | 12,525,000 |   |
| Percent of total revenue |       | 41                             | %          |   |   | 36 | % |
| SCOsource revenue        |       | 31,000                         |       | (100 | )% | 8,250,000 |   |
| Percent of total revenue |       | 0                              | %          |   |   | 24 | % |
| Other revenue            |       | 49,000                         |       | (69 | )% | 160,000 |   |
| Percent of total revenue |       | 1                              | %          |   |   | 0 | % |
|                          |            |                                |            |  |  |  |  |  |  |

 

The decrease in revenue in the Americas UNIX division for the secondquarter and first two quarters of fiscal year 2004 compared to the secondquarter and first two quarters of fiscal year 2003 was attributable tocontinued competition from other operating systems, particularly Linux, as wellas a decrease in revenue from corporate accounts.  The decrease in revenue in the InternationalUNIX division for the second quarter and first two quarters of fiscal year 2004

 

36

----

 

compared to the second quarter and first two quarters of fiscal year2003 was primarily related to the negative impact of the European economy aswell as from increased competition from other operating system products,particularly Linux, in Europe and Asia. We anticipate for the remainder of the 2004 fiscal year that UNIXrevenue generated by the Americas and the International UNIX divisions will beconsistent with or slightly lower than revenue generated by these two divisionsin the second quarter of fiscal year 2004 and that the percentage split betweenthese two UNIX divisions will be generally consistent with that in the secondquarter of fiscal year 2004.

 

Thedecrease in SCOsource licensing revenue in the second quarter and first twoquarters 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 $8,250,000 in SCOsource revenue in thesecond quarter and first two quarters of fiscal year 2003.  The SCOsource revenue generated in the secondquarter and first two quarters of fiscal year 2003 was from two contractsexecuted with Sun Microsystems (“Sun”) and Microsoft Corporation (“Microsoft”).

 

Our UNIX product and services revenue may be lower than currentlyanticipated if we lose the support of any of our existing hardware and softwarevendors or our key industry partners withdraw their marketing and certificationsupport or direct their support to our competitors.  This may occur as a result of our SCOsourceinitiatives and in particular as a result of any lawsuits we have broughtagainst end users violating our intellectual property and contractual rights oras a result of any adverse changes to our UNIX division.

 

*Products Revenue*
| ** **               | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                     |       |                             |       |   |   |   |   |
| Products revenue         |       | $                                | 8,415,000  |   | (24 | )% | $ | 11,122,000 |   |
| Percent of total revenue |       | 83                               | %          |   |   | 52 | % |
|                          |            |                                  |            |  |  |  |  |  |  |

 
| ** **               | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **2004**                       | ** ** | **Change** | ** ** | **2003** | ** ** |
|                     |       |                           |       |   |   |   |   |
| Products revenue         |       | $                              | 18,127,000 |   | (18 | )% | $ | 22,212,000 |   |
| Percent of total revenue |       | 84                             | %          |   |   | 64 | % |
|                          |            |                                |            |  |  |  |  |  |  |

 

Ourproducts revenue consists of software licenses of our UNIX products, primarilyOpenServer and UnixWare, as well as sales of UNIX-related products.  Products revenue also includes revenuederived from OEMs.  We rely heavily onour two-tier distribution channel for approximately 50 percent of our productsrevenue in the Americas UNIX division and over 90 percent of our revenue in ourInternational UNIX division, and any disruption in our distribution channelcould adversely impact our future revenue.

 

Thedecrease in products revenue in the second quarter and first two quarters of fiscalyear 2004 as compared with the second quarter and first two 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. This impact was felt in all of our distribution channels, and we believethat this competition from Linux will continue in future periods.

 

37

----

 

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

 
| ** **                  | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                             |       |   |   |   |   |
| OpenServer revenue          |       | $                                | 4,580,000  |   | (20 | )% | $ | 5,750,000 |   |
| Percent of products revenue |       | 54                               | %          |   |   | 52 | % |
| UnixWare revenue            |       | 2,425,000                        |       | (20 | )% | 3,017,000 |   |
| Percent of products revenue |       | 29                               | %          |   |   | 27 | % |
| Other products revenue      |       | 1,410,000                        |       | (40 | )% | 2,355,000 |   |
| Percent of products revenue |       | 17                               | %          |   |   | 21 | % |
|                             |            |                                  |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2004**                       | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                           |       |   |   |   |   |
| OpenServer revenue          |       | $                              | 9,782,000  |   | (7 | )% | $ | 10,491,000 |   |
| Percent of products revenue |       | 54                             | %          |   |   | 47 | % |
| UnixWare revenue            |       | 5,163,000                      |       | (28 | )% | 7,181,000 |   |
| Percent of products revenue |       | 28                             | %          |   |   | 32 | % |
| Other products revenue      |       | 3,182,000                      |       | (30 | )% | 4,540,000 |   |
| Percent of products revenue |       | 18                             | %          |   |   | 21 | % |
|                             |            |                                |            |  |  |  |  |  |  |

 

The decreases in OpenServer and UnixWare revenue as well as otherproducts revenue are the result of increased competition in the operatingsystem market, particularly Linux.

 

*SCOsourceLicensing Revenue*

 
| ** **                  | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                             |       |   |   |   |   |
| SCOsource licensing revenue |       | $                                | 11,000     |   | (100 | )% | $ | 8,250,000 |   |
| Percent of total revenue    |       | 0                                | %          |   |   | 39 | % |
|                             |            |                                  |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2004**                       | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                           |       |   |   |   |   |
| SCOsource licensing revenue |       | $                              | 31,000     |   | (100 | )% | $ | 8,250,000 |   |
| Percent of total revenue    |       | 0                              | %          |   |   | 24 | % |
|                             |            |                                |            |  |  |  |  |  |  |

 

SCOsourcelicensing revenue consists of revenue generated from vendor licenses to use ourproprietary UNIX System V code as well as IP licenses.  SCOsource licensing revenue was $11,000 forsecond quarter of fiscal year 2004 as compared to $8,250,000 in SCOsource revenuein the second quarter of fiscal year 2003, and SCOsource revenue was $31,000for the first two quarters of fiscal year 2004 as compared to $8,250,000 inSCOsource revenue for the first two quarters of fiscal year 2003.  The SCOsource revenue generated in the secondquarter of fiscal year 2003 was from two contracts executed with Sun andMicrosoft.

 

We generated minimal SCOsource revenue in the first and second quartersof fiscal year 2004, but anticipate that revenue from vendor licenses andintellectual property (“IP”) licenses will increase during the final twoquarters of fiscal year 2004.  However, we are unable to predict the amountand timing of revenue from our SCOsource initiatives for future periods becauseof the uncertainties related to the timing and revenue recognition of SCOsourcelicensing revenue.

 

38

----

* *

*Services Revenue*

 
| ** **               | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                     |       |                             |       |   |   |   |   |
| Services revenue         |       | $                                | 1,711,000  |   | (14 | )% | $ | 1,997,000 |   |
| Percent of total revenue |       | 17                               | %          |   |   | 9 | % |
|                          |            |                                  |            |  |  |  |  |  |  |

 
| ** **               | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **2004**                       | ** ** | **Change** | ** ** | **2003** | ** ** |
|                     |       |                           |       |   |   |   |   |
| Services revenue         |       | $                              | 3,371,000  |   | (24 | )% | $ | 4,447,000 |   |
| Percent of total revenue |       | 16                             | %          |   |   | 13 | % |
|                          |            |                                |            |  |  |  |  |  |  |

 

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 products sales.  Thedecrease in services revenue of $286,000, or 14 percent, in the second quarterof fiscal year 2004 as compared to the second quarter of fiscal year 2003 andthe decrease in services revenue of $1,076,000, or 24 percent, in the first twoquarters of fiscal year 2004 as compared to the first two quarters of fiscalyear 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.

 

Themajority of our support and professional services revenue continues to bederived from services for UNIX-based operating system products.  Our future level of services revenue dependsin part on our ability to generate UNIX products revenue from new customers aswell as the renewal of certain annual support and services agreements withexisting UNIX customers.  We anticipateour services revenue for the last two quarters of fiscal year 2004 to declineslightly from the revenue generated in the second quarter of fiscal year 2004.

 

*Cost of Products Revenue*

 
| ** **                     | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                           |       |                             |       |   |   |   |   |
| Cost of products revenue       |       | $                                | 901,000    |   | (25 | )% | $ | 1,206,000 |   |
| Percentage of products revenue |       | 11                               | %          |   |   | 11 | % |
|                                |            |                                  |            |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Six Months Ended April 30,** | ** ** |
|--------------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **2004**                       | ** ** | **Change** | ** ** | **2003** | ** ** |
| ** **                     | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of products revenue       |       | $                              | 1,789,000  |   | (25 | )% | $ | 2,392,000 |   |
| Percentage of products revenue |       | 10                             | %          |   |   | 11 | % |
|                                |            |                                |            |  |  |  |  |  |  |

 

Costof products revenue includes primarily overhead costs, manufacturing costs,royalties to third-party vendors and technology costs.  Cost of products revenue decreased by$305,000, or 25 percent, in the second quarter of fiscal year 2004 compared tothe second quarter of fiscal year 2003 and decreased by $603,000, or 25percent, in the first two quarters of fiscal year 2004 compared to the firsttwo quarters of fiscal year 2003.  Thisdecrease was primarily attributable to reduced product revenue and reducedoverhead and manufacturing costs resulting from our cost reduction efforts.

 

39

----

 

Forthe last two quarters of fiscal year 2004, we expect the dollar amount of ourcost of products revenue to be lower than our cost of products revenue incurredin the second quarter of fiscal year 2004.

 

*Cost ofSCOsource Licensing Revenue*

 
| ** **                                | ** ** | **Three Months Ended April 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                                      |       |                             |       |   |   |   |   |
| Cost of SCOsource licensing revenue       |       | $                                | 4,484,000  |   | 107 | % | $ | 2,163,000 |   |
| Percentage of SCOsource licensing revenue |       | 40763                            | %          |   |   | 26 | % |
|                                           |            |                                  |            |  |  |  |  |  |  |

 
| ** **                                | ** ** | **Six Months Ended April 30,** | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **2004**                       | ** ** | **Change** | ** ** | **2003** | ** ** |
|                                      |       |                           |       |   |   |   |   |
| Cost of SCOsource licensing revenue       |       | $                              | 7,924,000  |   | 266 | % | $ | 2,163,000 |   |
| Percentage of SCOsource licensing revenue |       | 25561                          | %          |   |   | 26 | % |
|                                           |            |                                |            |  |  |  |  |  |  |

 

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.

 

Costof SCOsource licensing revenue increased significantly in the second quarterand first two quarters of fiscal year 2004 compared to the second quarter andfirst two quarters of fiscal year 2003. This is primarily the result of increased legal fees incurred inconnection with our ongoing litigation with IBM, Novell, AutoZone andDaimlerChrysler as well as for the pursuit of intellectual propertylicenses.  For the last two quarters offiscal year 2004, we expect our cost of SCOsource licensing revenue to begenerally consistent with our cost of SCOsource license revenue generated inthe second quarter of fiscal year 2004. However, cost of SCOsource licensing revenue likely will fluctuate fromquarter to quarter due in part to the unpredictability of the related SCOsourcerevenue and the level of legal and professional expenses incurred in connectionwith our efforts to protect our intellectual property rights.  Legal expenses could increase over timedepending on developments in our ongoing litigation.  Legal expenses may also include contingency paymentsmade to the law firms engaged by us to protect our intellectual propertyrights, which at this time we are unable to predict the amount or timing ofsuch contingency fees.  Additionally, weare unable to predict the percentage of cost of SCOsource licensing revenue forfuture quarters due to the unpredictability of the related licensing revenue.

 

*Cost of Services Revenue*

 
| ** **                     | ** ** | **Three Months Ended April 30,** | ** ** |
|--------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                           |       |                             |       |   |   |   |   |
| Cost of services revenue       |       | $                                | 1,073,000  |   | (40 | )% | $ | 1,778,000 |   |
| Percentage of services revenue |       | 63                               | %          |   |   | 89 | % |
|                                |            |                                  |            |  |  |  |  |  |  |

 
| ** **                     | ** ** | **Six  Months Ended April 30,** | ** ** |
|--------------------------------|------------|---------------------------------|------------|
| ** **                     | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                           |       |                            |       |   |   |   |   |
| Cost of services revenue       |       | $                               | 2,395,000  |   | (31 | )% | $ | 3,470,000 |   |
| Percentage of services revenue |       | 71                              | %          |   |   | 78 | % |
|                                |            |                                 |            |  |  |  |  |  |  |

 

40

----

 

Costof services revenue includes the salaries and related personnel costs ofemployees delivering services revenue as well as third-party serviceagreements.  Cost of services revenuedecreased by $705,000, or 40 percent, for the second quarter of fiscal year2004 compared to the second quarter of fiscal year 2003 and decreased by$1,075,000, or 31 percent, for the first and second quarters of fiscal year2004 compared to the first and second quarters of fiscal year 2003.  This decrease was attributable in partto lower services revenue, reduced employee and related costs in our supportservices and professional services groups as well as the elimination of certainthird-party support contracts in order to increase the gross margin for thesegroups.

 

Forthe last two quarters of fiscal year 2004, we expect the dollar amount of ourcost of services revenue to be lower than our cost of services revenue incurredin the second quarter of fiscal year 2004.

 

*Sales and Marketing*

 
| ** **                  | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                             |       |   |   |   |   |
| Sales and marketing expense |       | $                                | 4,698,000  |   | (22 | )% | $ | 6,051,000 |   |
| Percentage of total revenue |       | 46                               | %          |   |   | 28 | % |
|                             |            |                                  |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Six Months Ended April 30,** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **2004**                       | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                           |       |   |   |   |   |
| Sales and marketing expense |       | $                              | 9,719,000  |   | (22 | )% | $ | 12,491,000 |   |
| Percentage of total revenue |       | 45                             | %          |   |   | 36 | % |
|                             |            |                                |            |  |  |  |  |  |  |

 

Salesand marketing expenses consist of the salaries, commissions and other personnelcosts of employees involved in the revenue generation process, as well asadvertising and corporate allocations. The decrease in sales and marketing expenses from the second quarter offiscal year 2003 to the second quarter of fiscal year 2004 of $1,353,000, or 22percent, and the decrease in sales and marketing expense from the first twoquarters of fiscal year 2003 to the first two quarters of fiscal year 2004 of$2,772,000, or 22 percent, was primarily attributable to reductions insales and marketing employees, reduced travel expenses, and lower commissionsand lower co-operative advertising costs as a result of lower revenue.  Our sales and marketing headcount decreasedfrom 134 as of April 30, 2003, to 82 as of April 30, 2004.

 

Forthe last two quarters of fiscal year 2004, we anticipate the dollar amount ofsales and marketing expenses will decrease compared to the second quarter offiscal year 2004.

 

*Research and Developmen*t

 
| ** **                       | ** ** | **Three Months Ended April 30,** | ** ** |
|----------------------------------|------------|----------------------------------|------------|
| ** **                       | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                             |       |                             |       |   |   |   |   |
| Research and development expense |       | $                                | 2,868,000  |   | 13 | % | $ | 2,542,000 |   |
| Percentage of total revenue      |       | 28                               | %          |   |   | 12 | % |
|                                  |            |                                  |            |  |  |  |  |  |  |

 
| ** **                       | ** ** | **Six  Months Ended April 30,** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                             |       |                            |       |   |   |   |   |
| Research and development expense |       | $                               | 5,575,000  |   | 7 | % | $ | 5,192,000 |   |
| Percentage of total revenue      |       | 26                              | %          |   |   | 15 | % |
|                                  |            |                                 |            |  |  |  |  |  |  |

 

Researchand development expenses consist of the salaries and benefits of softwareengineers, consulting expenses as well as corporate allocations. The increasein research and

 

41

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developmentexpense in the second quarter of fiscal year 2004 of $326,000, or 13 percent,compared to the second quarter of fiscal year 2003 and the increase in researchand development expense in the first two quarters of fiscal year 2004 of$383,000, or 7 percent, compared to the first two quarters of fiscal year 2003was primarily attributable to increased personnel and related costsattributable to development work and enhancements of our two UNIX operatingsystem products, OpenServer and UnixWare. Our research and development personnel increased from 70 as of April 30,2003, to 85 as of April 30, 2004.

 

Forthe last two quarters of fiscal year 2004, we anticipate the dollar amount ofresearch and development expenses will decrease compared to the second quarterof fiscal year 2004 due to recently implemented cost reductions.

 

*General and Administrative*

 
| ** **                         | ** ** | **Three  Months Ended April 30,** | ** ** |
|------------------------------------|------------|-----------------------------------|------------|
| ** **                         | ** ** | **2004**                          | ** ** | **Change** | ** ** | **2003** | ** ** |
|                               |       |                              |       |   |   |   |   |
| General and administrative expense |       | $                                 | 2,392,000  |   | 64 | % | $ | 1,462,000 |   |
| Percentage of total revenue        |       | 24                                | %          |   |   | 7 | % |
|                                    |            |                                   |            |  |  |  |  |  |  |

 
| ** **                         | ** ** | **Six  Months Ended April 30,** | ** ** |
|------------------------------------|------------|---------------------------------|------------|
| ** **                         | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                               |       |                            |       |   |   |   |   |
| General and administrative expense |       | $                               | 4,586,000  |   | 47 | % | $ | 3,112,000 |   |
| Percentage of total revenue        |       | 21                              | %          |   |   | 9 | % |
|                                    |            |                                 |            |  |  |  |  |  |  |

 

Generaland administrative expenses consist of the salaries and benefits of finance,human resources and executive management and expenses for professional servicesas well as corporate allocations. Included in general and administrative expenses for the three and sixmonths ended April 30, 2004 are $682,000 in payments made in connection withthe elimination of approximately 16 percent of our workforce.  The increase in general and administrativeexpense from the second quarter and first two quarters of fiscal year 2003 of$930,000 and $1,474,000, respectively, compared to the second quarter and firsttwo quarters of fiscal year 2004, exclusive of the above mentioned terminationpayments, was primarily attributable to new compliance and reportingregulations under the Sarbanes-Oxley Act of 2002 and other new regulatoryrequirements, increased legal costs as a result of corporate legal matters andother legal and professional costs not categorized as SCOsource cost ofrevenue.

 

Forthe last two quarters of fiscal year 2004, we anticipate the dollar amount ofgeneral and administrative expenses will decrease compared to the secondquarter of fiscal year 2004 due to recently implemented cost reductions.

 

*RestructuringCharges (Reversals)*

* *
| ** **                        | ** ** | **Three Months Ended April 30,** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|
| ** **                        | ** ** | **2004**                         | ** ** | **Change** | ** ** | **2003** | ** ** |
|                              |       |                             |       |   |   |   |   |
| Restructuring charges (reversals) |       | $                                | —     |   | n/a |   | $ | 136,000 |   |
| Percentage of total revenue       |       | 0                                | %          |   |   | 1 | % |
|                                   |            |                                  |            |  |  |  |  |  |  |

* *
| ** **                        | ** ** | **Six  Months Ended April 30,** | ** ** |
|-----------------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                              |       |                            |       |   |   |   |   |
| Restructuring charges (reversals) |       | $                               | —     |   | n/a |   | $ | (116,000 | ) |
| Percentage of total revenue       |       | 0                               | %          |   |   | (0 | )% |
|                                   |            |                                 |            |  |  |  |  |  |  |

 

42

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In March 2003, in connection with management’s decision to establishstrategic European headquarters in Dublin, Ireland, and our United Kingdom (“UK”)subsidiary, SCO Group, Ltd., not performing at expected levels, we determinedthat SCO Group, Ltd would be wound up. On March 26, 2003, the board of directors of SCO Group, Ltd., obtainedadministrative relief in accordance with Rule 2.2 of the Insolvency Rules 1986of the UK.  In connection with theapproved administrative relief, the operations of SCO Group, Ltd. weretransferred to an administrator that was appointed by the court to complete thewinding-up process.  As of April 30,2003, the operations of SCO Group, Ltd. were no longer under our control.  The winding-up of SCO Group, Ltd. resulted ina net restructuring charge during the quarter ended April 30, 2003 of$136,000.  The net reversal for the firsttwo quarters of fiscal year 2003 was a result of the restructuring chargediscussed above related to our UK subsidiary and additional adjustments to previouslyrecorded restructuring charges for actual payments made.

 

*Amortization of Intangibles*

 
| ** **                  | ** ** | **Three  Months Ended April 30,** | ** ** |
|-----------------------------|------------|-----------------------------------|------------|
| ** **                  | ** ** | **2004**                          | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                              |       |   |   |   |   |
| Amortization of intangibles |       | $                                 | 593,000    |   | (15 | )% | $ | 700,000 |   |
| Percentage of total revenue |       | 6                                 | %          |   |   | 3 | % |
|                             |            |                                   |            |  |  |  |  |  |  |

 
| ** **                  | ** ** | **Six  Months Ended April 30,** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Amortization of intangibles |       | $                               | 1,380,000  |   | (1 | )% | $ | 1,400,000 |   |
| Percentage of total revenue |       | 6                               | %          |   |   | 4 | % |
|                             |            |                                 |            |  |  |  |  |  |  |

 

Amortizationof intangibles is the expensing of previously recorded amounts for assetsrecorded in prior acquisitions with finite lives.  The decrease in amortization of intangiblesof $107,000 for the second quarter of fiscal year 2004 compared to the secondquarter of fiscal year 2003 was primarily attributable to reduced amortizationexpense recorded on certain assets and technology acquired from The Santa CruzOperation (now Tarantella, Inc.).

 

*Loss on Impairment of Long-lived Assets*

 

We recorded a loss on impairment of long-lived assets totaling$2,139,000 for the second quarter and first two quarters of fiscal year 2004.  The impairment related to goodwill andintangible assets acquired in connection with our acquisition of Vultus in June2003.  We concluded that an impairmenttriggering event occurred during the three months ended April 30, 2004 as animpending partnership that would solidify the Vultus revenue and cash flowopportunities did not materialize. Consequently, we have concluded that no significant future cash flowsrelated to our Vultus assets will be realized. We performed an impairment analysis of our recorded goodwill related tothe Vultus reporting unit in accordance with SFAS No. 142.  Additionally, an impairment analysis of theintangible assets was performed in accordance with SFAS No. 144.  As a result of these analyses, we wrote-downthe carrying value of our goodwill related to our Vultus acquisition from$1,166,000 to $0, and wrote-down the intangible assets related to our Vultusacquisition from $973,000 to $0.  We didnot incur any impairment charges in the second quarter or first two quarters offiscal year 2003.

 

43

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*Stock-based Compensation*

* *
| ** **                  | ** ** | **Three  Months Ended April 30,** | ** ** |
|-----------------------------|------------|-----------------------------------|------------|
| ** **                  | ** ** | **2004**                          | ** ** | **Change** | ** ** | **2003** | ** ** |
| ** **                  | ** ** | **(restated)**                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock-based compensation    |       | $                                 | 163,000    |   | (60 | )% | $ | 406,000 |   |
| Percentage of total revenue |       | 2                                 | %          |   |   | 2 | % |
|                             |            |                                   |            |  |  |  |  |  |  |

* *
| ** **                  | ** ** | **Six  Months Ended April 30,** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **2004**                        | ** ** | **Change** | ** ** | **2003** | ** ** |
|                        |       |                            |       |   |   |   |   |
| Stock-based compensation    |       | $                               | 598,000    |   | (3 | )% | $ | 618,000 |   |
| Percentage of total revenue |       | 3                               | %          |   |   | 2 | % |
|                             |            |                                 |            |  |  |  |  |  |  |

 

Stock-based compensation consisted of the following components for thethree and months ended April 30, 2004 and 2003 (in thousands):

 
| ** **                               | ** ** | **Three  Months Ended April 30,** | ** ** | **Six  Months Ended April 30,** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **2004**                          | ** ** | **2003**                        | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                               | ** ** | **(restated)**                    | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Amortization of stock-based compensation |       | $                                 | 113        |                            | $          | 239 |   | $ | 223 |   | $ | 396 |   |
| Options and shares for services          |       | 50                                |       | 167                             |       | 283 |   | 222 |   |
| Modifications to options                 |       | —                            |       | —                          |       | 92 |   | — |   |
| Total                                    |       | $                                 | 163        |                            | $          | 406 |   | $ | 598 |   | $ | 618 |   |

 

*Equity in Income (Losses) of Affiliates*

 

We account for our ownership interests in companies that we own atleast 20 percent and less than 50 percent using the equity method ofaccounting.  Under the equity method, werecord our portion of the entities’ net income or net loss in our condensedconsolidated statements of operations. During the second quarter and first two quarters of fiscal year 2004 werecorded income of $37,000 and $74,000, respectively, primarily related toincome from our joint venture in China compared to a loss of $75,000 and$100,000, respectively, in the second quarter and first two quarters of fiscalyear 2003 primarily related to our investment in Vista, Inc. (“Vista”).  We disposed of our investment in Vista infiscal year 2003.

 

*Other Income (Expense), net*

 

Other income (expense) consisted of the following components for thethree and six months ended April 30, 2004 and 2003 (in thousands):

 
| ** **                         | ** ** | **Three Months Ended April 30,** | ** ** | **Six Months Ended April 30,** | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                               |       |                             |       |                           |       |   |   |   |   |
| Interest income                    |       | $                                | 242        |                           | $          | 11 |   | $ | 512 |   | $ | 50 |   |
| Change in fair value of derivative |       | 2,300                            |       | —                         |       | 5,924 |   | — |   |
| Other expense, net                 |       | (120                             | )          | (59                            | )          | (251 | ) | (54 | ) |
| Total other income (expense), net  |       | $                                | 2,422      |                           | $          | (48 | ) | $ | 6,185 |   | $ | (4 | ) |

 

Interest income increased by $231,000 for the second quarter of fiscalyear 2004 compared to the second quarter of fiscal year 2003 and increased by$462,000 for the first two quarters of fiscal year 2004 compared to the firsttwo quarters of fiscal year 2003 as a result of interest earned on higher cashbalances.  The income recorded of$2,300,000 on the change in fair value of the derivative related to thenow-exchanged Series A shares for the second quarter of fiscal year 2004

 

44

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which represented the change in fair value between February 5, 2004(the date of the exchange of all Series A shares for Series A-1 shares) andJanuary 31, 2004.  For the first quarterof fiscal year 2004, we recorded income of $3,624,000 for the change in fairvalue of the derivative between October 31, 2003 and January 31, 2004.

 

*Provision for IncomeTaxes*

 

The provision for income taxes was $966,000in the second quarter of fiscal year 2004 and $302,000 in the second quarter offiscal year 2003 and $1,094,000 for the first two quarters of fiscal year 2004and $307,000 for the first two quarters of fiscal year 2003.  Theincrease in the provision for income taxes for the second quarter and first twoquarters of fiscal year 2004 compared to the second quarter and first twoquarters of fiscal year 2003 was primarily attributable to accruals forwithholding taxes that are estimated to be paid in connection with theoperations of the Indian branch of our United Kingdom subsidiary, SCO Group,Ltd.

 

During the three months ended April 30, 2004, the Indian branchreceived a withholding tax assessment from the Government of India Income TaxDepartment (“Tax Department”) for the period of April 2000 through March2001.  During the April 2000 throughMarch 2001 period, SCO Group, Ltd. was owned by The Santa Cruz Operation (nowTarantella, Inc.), and not us.  Weacquired SCO Group, Ltd. in May 2001 as part of an asset purchase.

 

The Tax Department assessed SCO Group, Ltd. with a 15 percentwithholding tax on certain revenue transactions in India that the TaxDepartment deemed royalty revenue under the Indian Income Tax Act.  The total amount of the withholding tax is$396,000.  We were not aware of thisliability until March 2004, when we received the formal tax assessment from theTax Department, as we believed that we had been appropriately accounting forthe revenue and related taxes on transactions in India.

 

We have filed an appealwith the Tax Department and believe that our packaged software does not qualifyfor “royalties” treatment and would therefore not be subject to withholdingtax.  Additionally, as described above inthis Item 2., under the caption “Restructuring Charges (Reversals),” SCO Group,Ltd, the company on which the assessment was levied, has filed for bankruptcyin the UK.  Although we intend tovigorously defend this tax assessment, there can be no assurance we willprevail against the Tax Department.

 

We have recorded thecharge for $396,000 in the in the second and first two quarters of fiscal year2004 as a component of our provision for income taxes.  In addition, we believe that the TaxDepartment probably will pursue similar assessments on SCO Group, Ltd. fortaxable periods subsequent to March 2001. Because of this probability, and our inability to determine at thispoint if we may prevail against the Tax Department, we have accrued the fullamount of the estimated withholding tax of $314,000 for these subsequentperiods as provision for income taxes in our statements of operations for thesecond quarter and first two quarters of fiscal year 2004.

 

*Dividends Related to Redeemable Convertible Preferred Stock*

 

### **In connection with completing theFebruary 5, 2004 exchange of Series A-1 shares for Series A shares, we removedthe carrying value of the Series A shares and related derivative and recordedthe fair value of the Series A-1 shares issued in the exchangetransaction.  The difference betweenthese two amounts was $6,305,000 and was recorded as a non-cash dividend forthe second quarter and first two quarters of fiscal year 2004.**

 

### **Additionally, with respect to theSeries A-1 shares currently outstanding, dividends will begin to accrue fromOctober 16, 2004, the first anniversary of our original October 16, 2003private placement of Series A shares, and will be paid quarterly beginning inthe 30-day period**

### ** **

45

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### **following January 31, 2005 at a rate of 8 percentper annum, subject to annual increases of 2 percent per annum, not to exceed 12percent per annum. **Because dividends on the Series A-1 shares are not payableuntil after January 31, 2005, we have accrued dividends of $756,000 for thefirst quarter of fiscal year 2004 and an additional $740,000 in dividends forthe second quarter of fiscal year 2004.  We had no dividends accrued or payable in the second quarter or firsttwo quarters of fiscal year 2003.  If werepurchase the outstanding Series A-1 shares as contemplated in our May 31,2004 agreement with BayStar as described in more detail above in this Item 2.,under the caption “Recent Developments,” then we will not be obligated to paysuch dividends on the Series A-1 shares.

 

**Liquidity and Capital Resources**

 

Our cash and equivalents and available-for-sale securities balancesdecreased from $68,523,000 as of October 31, 2003 to $61,346,000 as of April30, 2004; however, our working capital increased from $37,168,000 as of October31, 2003 to $37,937,000 as of April 30, 2004. Our cash and equivalents decreased from $64,428,000 as of October 31,2003 to $21,042,000  as of April 30,2004, primarily as a result of cash used in operations, principally from ourSCOsource division, and cash used to purchase available-for-sale securities.

 

During fiscal year 2003, we generated positive cash flow fromoperations for the first time in our operating history.  This was achieved through reductions in costsand increased gross margin generated from our UNIX business and significantlicense revenue generated from our SCOsource business.  We also completed our private placement of50,000 Series A shares for net proceeds of $47,740,000 in October 2003, whichshares were exchanged for Series A-1 shares in February 2004.  If we repurchase the outstanding Series A-1shares from BayStar pursuant to our May 31, 2004 agreement, then the netproceeds received in our private placement would be reduced by the $13,000,000cash component of the repurchase price. We intend to use the net proceeds from our preferred stock financing aswell as our other cash resources to pursue our SCOsource initiatives.  We believe that we will have sufficient cashresources to complete the Series A-1 repurchase transaction and fund ourcurrent operations for at least the next 12 months.

 

Our net cash used in operations for the first two quarters of fiscalyear 2004 was $5,206,000 compared to cash generated from operations of$3,173,000 for the first two quarters of fiscal year 2003.  Cash used in operations in the first twoquarters of fiscal year 2004 included a net loss of $9,411,000, non-cashexpenses of $1,280,000 and changes in operating assets and liabilities of$5,485,000.  Our current liabilities decreasedfrom $45,112,000 as of October 31, 2003 to $34,335,000 as of April 30, 2004primarily related to the elimination of the fair-value of the derivativerelated to our now-exchanged Series A shares and the decrease in accruedcompensation to law firms, which were offset by an increase in accruedliabilities.

 

Our investing activitieshave historically consisted of equipment purchases, investing in strategicpartners and the purchase and sale of available-for-sale securities.  During the first two quarters of fiscal year2004, cash used in investing activities was $36,604,000, which was primarily aresult of our purchase of available-for-sale securities (net of sales) of$36,209,000, equipment purchases of $186,000 and cash used to acquire theoutstanding minority interest in our Japanese subsidiary of $209,000.  Cash used in investing activities was$778,000 for the first two quarters of fiscal year 2003 and primarilyattributable to equipment purchases of $328,000 and the investment innon-marketable securities of $450,000.

 

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

 

46

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stock purchase programof $370,000.  Cash provided by financingactivities was $782,000 for the first two quarters of fiscal year 2003 and wasattributable to proceeds received from the exercise of stock options of $225,000,the issuance of a warrant of $500,000 and proceeds from the purchase of sharesof common stock by our employees through our employee stock purchase program of$57,000.

 

The Certificate ofDesignation, Rights and Preferences creating our Series A-1 shares includesredemption provisions that, if triggered, would require us to repurchase forcash the outstanding shares of our Series A-1 shares.  Our redemption obligation may be triggered bycertain events including, among others, our company or any of its subsidiariesmaking an assignment for the benefit of creditors or consenting to theappointment of a trustee or receiver for it or a substantial part of itsbusiness, the bankruptcy, reorganization, liquidation or similar proceedingsinstituted by or against our company or any of its subsidiaries, a change incontrol event occurring with respect to our company or our failure to pay whendue any indebtedness in excess of $1,000,000 or otherwise our default under anyagreement binding us that would likely result in a material adverse effect onour business.

 

As stated above in this Item 2, under the caption “RecentDevelopments,” on April 15, 2004, we received a redemption notice from BayStarrequesting that we immediately redeem 20,000 shares of our Series A-1 sharesthen held by BayStar.  The redemptionnotice asserted that BayStar is entitled to redemption of its shares under theCertificate of Designation for the Series A-1 shares because we allegedly hadbreached certain provisions of our February 5, 2004 exchange agreement relatingto our exchange of Series A shares for Series A-1 shares.  BayStar’s redemption notice did not providespecific information regarding the factual basis for our alleged breaches ofthe exchange agreement, but we do not believe we have breached the ExchangeAgreement.  As a result, we do notbelieve we are obligated to redeem BayStar’s Series A-1 shares.  However, ifwe were required to pay cash to redeem BayStar’s Series A-1 shares pursuant tothe redemption notice or otherwise pursuant to the Certificate of Designationfor the Series A-1 shares, it would have a material and adverse impact on ourliquidity, which may require us to obtain additional sources of cash to sustainoperations.

 

Dividends on our Series A-1 shares, if not repurchased pursuant to ourMay 31, 2004 stock repurchase agreement with BayStar, will begin accruing fromOctober 16, 2004 and will be paid quarterly beginning in the 30-day periodfollowing January 31, 2005 at a rate of 8 percent per annum, subject to annualincreases of 2 percent per annum, not to exceed 12 percent per annum.    Dividendsmay be paid in cash or additional Series A-1 shares, subject to certainlimitations.

 

If we do complete ourpreviously announced Series A-1 share repurchase transaction with BayStar, wewill pay to BayStar $13,000,000 in cash and issue 2,105,263 shares of ourcommon stock, payable and issuable upon the effectiveness of a shelfregistration statement for the resale of the common stock issued to BayStar.  The payment to BayStar will have a negativeimpact on our cash and working capital position, but will eliminate allremaining issued and outstanding Series A-1 shares and associated rights andpreferences related to dividends, liquidation payments, voting and others.

 

Our net accountsreceivable balance decreased by $2,471,000 from $9,282,000 as of October 31,2003 to $6,811,000 as of April 30, 2004. This decrease was primarily attributable to the collection of year-endreceivables and lower overall invoicing during the second quarter of fiscalyear 2004.  The majority of our accountsreceivable are current and our allowance for doubtful accounts wasapproximately $155,000 as of April 30, 2004, which represented approximately 2percent of our gross accounts receivable balance.  This allowance as a percentage of grossaccounts receivable is consistent with our experience in prior periods, and weexpect this trend to continue.  Ourwrite-offs of uncollectible accounts during the second quarter of fiscal year2004 were not significant.

 

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During fiscal year 2003,we expanded our efforts with the law firms assisting us with our pursuit of ourintellectual property claims and currently expect to devote substantially morefinancial resources to this effort.  Inaddition to paying fees at reduced hourly rates to these firms, our agreementwith the law firms provides that we will pay the law firms a contingency fee of20 percent of the proceeds from specified events related to the protection ofour intellectual property rights.  Theseevents may include settlements, judgments, certain 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 agreement with the lawfirms may also be construed to include contingency fee payments in connectionwith our issuance of equity securities, which may harm our results ofoperations as we anticipate that these costs to the law firms will be expensedas incurred.

 

We expect that legalfees for the last two quarters of fiscal year 2004 paid to the law firms wehave engaged to pursue our intellectual property claims will be consistent tothe level of fees incurred during the second quarter of fiscal year 2004.  However, legal expenses could increase overtime depending on developments in litigation involving us, and certain eventsoutside of our control could occur or certain contingent events could takeplace that would require us to pay additional fees to the law firms.  To the extent that our SCOsource relatedcosts and legal fees exceed our budgeted amounts in future quarters of fiscalyear 2004 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.  Ourcompensation arrangement with our law firms could also impair our ability toraise equity capital in future periods.

 

We have entered intooperating leases for our corporate offices located in the United States and ourinternational sales offices.  We havecommitments under these leases that extend through fiscal year 2010.  In corporate restructuring activities duringfiscal years 2001 through 2003, we partially vacated some of these facilities,but still have contractual obligations to continue to make ongoing leasepayments for one facility that will use available cash.  We have pursued and will continue to pursuesublease opportunities, as available, to minimize this use of cash; however, wemay not be successful in eliminating or reducing cash expenditures for thisfacility.

 

The following tablesummarizes our contractual lease obligations as of April 30, 2004:

 
| ** **                  | ** ** | **Total**  | ** ** | **Less than  1 year** | ** ** | **1 – 3 years** | ** ** | **More than  3 years** | ** ** |
|-----------------------------|------------|------------|------------|-----------------------|------------|----------------------|------------|------------------------|------------|
| ** **                  | ** ** | ** ** | ** ** | ** **            | ** ** | ** **           | ** ** | ** **             | ** ** |
| Operating lease obligations |       | $          | 6,748,000  |                  | $          | 2,702,000            |       | $                      | 3,277,000  |   | $ | 769,000 |   |
|                             |            |            |            |                       |            |                      |            |                        |            |  |  |  |  |

 

As of April 30, 2004, wedid not have any long-term debt obligations, purchase obligations or materialcapital lease obligations.

 

Our ability to cut coststo offset revenue declines in our UNIX business is limited to a certain extentbecause of contractual commitments to maintain and support our existing UNIXcustomers.  The decline in our UNIXbusiness may be accelerated if industry partners withdraw their support as aresult of our SCOsource initiatives and in particular any lawsuits against endusers violating our intellectual property and contractual rights.  Our SCOsource initiatives, particularlylawsuits against such end users, may cause industry partners, developers andhardware and software vendors to choose not to support or certify to our UNIXoperating system products.  This may leadto an accelerated decline in our UNIX products and services revenue.  If

 

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our UNIX products and services revenue is lessthan expected, our liquidity will be adversely impacted.

 

In the event that cashrequired to fund operations and strategic initiatives exceeds our current cashresources and cash generated from operations, we will be required to reducecosts and perhaps raise additional capital. We may not be able to reduce costs in a manner that does not impair ourability to maintain our UNIX business and pursue our SCOsourceinitiatives.  We may also not be able toraise capital for any number of reasons including those listed under thesection “Risk Factors” below.  Ourability to raise additional equity capital is restricted under the terms of ourSeries A-1 shares.  If additional equityfinancing is available, it may not be available to us on attractive terms andmay be dilutive to our existing stockholders. Our ability to raise debt financing is restricted under the terms of ourSeries A-1 shares.  In addition, if ourstock price declines, we may not be able to access the public equity markets onacceptable terms, if at all.  Our abilityto effect acquisitions for stock would also be impaired.

 

As discussed elsewhere above in Part I, Item 1 ofthis Amendment No. 1 to Form 10-Q/A, we issued shares and granted options underthe Plans without complying with registration or qualification requirementsunder federal securities laws and the securities laws of certain states.  As a result, certain Plan participants have aright to rescind their purchases of shares under the Plans or recover damagesif they no longer own the shares or hold unexercised options, subject toapplicable statutes of limitations, and we may make a rescission offer tocertain of such Plan participants subject to obtaining required regulatoryapprovals.  Additionally, regulatoryauthorities may require us to pay fines or they may impose other sanctions onus, and we may face other claims by Plan participants other than rescissionclaims.

 

If our potentialrescission offer is made and accepted by Plan participants holding sharesacquired under the Plans or otherwise entitled to recover damages from us inrespect of such shares they have sold, or such Plan participants otherwise makerescission claims against us, we could be liable to make aggregate payments tothese Plan participants of up to $231,000 in the aggregate, excluding interestand other possible fees, based upon shares outstanding under the Plans as ofApril 30, 2004.

 

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

 

We may also be required to pay interest and penalties up to statutorylimits in connection with Plan participants making rescission claims or inconnection with any rescission offer.  Webelieve that it is reasonably possible that we may be required to pay interestand penalties, but are not able to estimate an amount.

 

On March 10, 2004, our board of directors authorized management, in itsdiscretion, to purchase up to 1,500,000 shares of our common stock over a24-month period.  Shares may be purchasedin open market transactions, block purchases or privately negotiatedtransactions.  Any repurchased shareswill be held as treasury stock and will be available for general corporatepurposes.  During the second quarter of fiscal year 2004, a total of290,000 shares of our common stock were repurchased for a total of$2,414,000.  If we continue to repurchasea substantial number of shares during this 24-month period, and we do notgenerate off-setting revenue form our UNIX and SCOsource businesses, our cashposition could decrease significantly and our

 

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ability to fund future operations could be adversely impacted.  Purchases under stock repurchase program aresubject to the discretion of management based on market conditions and otherfactors including the trading price of our common stock, availability of stock,alternative uses of capital and our financial condition.

 

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

 

*Foreign Currency Risk. *Wehave foreign offices and operations in Europe and Asia.  As a result, a portion of our revenue isderived from sales to customers outside the United States.  Most of this international revenue isdenominated in U.S. dollars.  However,most of the operating expenses related to our foreign-based operations are denominatedin foreign currencies and therefore operating results are affected by changesin the U.S. dollar exchange rate in relation to foreign currencies such as theEuro, among others.  If the U.S. dollarremains weak 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 ofunderlying assets and liabilities.  We donot use forward exchange contracts for speculative or trading purposes.  Our accounting policies for these instrumentsare based on our designation of such instruments.  The criteria we use for designating aninstrument include the instrument’s effectiveness in risk reduction andone-to-one matching of forward exchange contracts to underlying assets andliabilities.  Gains and losses oncurrency forward contracts that are firm commitments are deferred andrecognized in income in the same period that the underlying transactions aresettled.  Gains and losses on currencyforward contracts that are designated and effective for existing transactionsare recognized in income in the same period as losses and gains on theunderlying transactions are recognized and generally offset.  Gains and losses on any instruments notmeeting the above criteria are recognized in income in the current period.  As of April 30, 2004, we had no outstandinginstruments classified as hedges.

 

*Interest Rate Risk. *Theprimary objective of our cash management strategy is to invest available fundsin a manner that assures maximum safety and liquidity and maximizes yieldwithin such constraints.  We do notborrow money for short-term investment purposes.

 

*Investment Risk. *Wehave invested in equity instruments of privately held and public companies inthe technology industry for business and strategic purposes.  Investments are accounted for under the costmethod if our ownership is less than 20 percent and we are not able to exerciseinfluence over operations.  Ourinvestment policy is to regularly review the assumptions and operatingperformance of these companies and to record impairment losses when events andcircumstances indicate that these investments may be impaired.  As of April 30, 2004, our investments balancewas approximately $524,000 and was related to our investment in a 30 percentowned Chinese company.

 

The stock market ingeneral, and the market for shares of technology companies in particular, hasexperienced extreme price fluctuations. In addition, factors such as new product introductions by ourcompetitors or developments in the litigation related to our SCOsourceinitiatives may have a significant impact on the market price of our commonstock.  Furthermore, quarter-to-quarterfluctuations in our results of operations caused by changes in customer demandmay have a significant impact on the market price of our common stock.  These conditions could cause the price of ourcommon stock to fluctuate substantially over short periods of time.

 

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

 

Under the supervisionand with the participation of our management, including our Chief ExecutiveOfficer and Chief Financial Officer, we evaluated the effectiveness of thedesign and operation of our disclosure controls and procedures (as defined inRule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “ExchangeAct”)).  Based upon that evaluation, andsubsequent evaluations, the Chief Executive Officer and Chief Financial Officerconcluded that, as of the end of the period covered by this report and as aresult of the material weakness in our internal controls described below, ourdisclosure controls and procedures were noteffective to ensure that information required to be disclosed by us in thereports we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in applicable rulesand forms.

 

We have a materialweakness with respect to accounting for capital stock and stock optiontransactions.  We have issued certainshares of our common stock under our equity compensation plans withoutcomplying with the registration requirements of federal and applicable statesecurities laws.  As a result, theholders of such shares may have a rescission right, and, consequently, certainamounts the Company received upon purchase of such shares must be reclassifiedfrom permanent equity to temporary equity. We reclassified from permanent equity to temporary equity $231,000related to certain shares of common stock issued under the Company’s equitycompensation plans that are subject to rescission.  We determined that we lacked procedures toreconcile shares issued with shares available under registration statements ina timely manner.

 

In addition, weincorrectly accounted for dividends on Series A Convertible Preferred Stock bynot recording dividends payable of $1,619,000 as of April 30, 2004.  We have also overstated compensation expenseby not properly accounting for a non-routine stock option grant to a non-employeeby $233,000 for the three months ended April 30, 2004.  We determined that we lacked resources withproper experience to review the Company’s accounting for capital stock andstock option transactions.

 

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

 

During the quartercovered by this quarterly report, there has been no change in our internal controlover financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under theExchange Act) that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.  However, as discussed above, changes havebeen implemented subsequent to the end of the quarter covered by this quarterlyreport to add additional controls to correct the material weakness in internalcontrol over financial reporting.

 

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

#### *** ***

#### ***With theexception of historical facts, the statements contained in Management’sDiscussion and Analysis of Financial Condition and Results of Operations are “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, which reflect our current expectations and beliefs regarding ourfuture results of operations, performance and achievements. These statementsare subject to risks and uncertainties and are based upon assumptions andbeliefs that may or may not materialize. These forward-looking statements include, 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, whichenhancements we believe will help prolong our UNIX revenue stream for futurequarters;

 

•                                          Our estimation that the decline in our UNIXbusiness revenue may be accelerated if industry partners withdraw their supportas a result of our SCOsource initiatives and inparticular any lawsuits against end users violating our intellectual propertyand contractual rights;

 

•                                          Ourbelief that the cuts made to our UNIX operations in the second quarter offiscal year 2004 will have a positive impact on our operations for the last twoquarters of fiscal year 2004;

 

•                                          Ourbelief that the future success of our SCOsourceinitiatives will depend on our ability to protect our intellectual property,our intention to continue to devote resources to our SCOsourceinitiatives and our expectation that quarterly legal fees and other SCOsource related costs for the remaining quarters offiscal year 2004 will be consistent with the level of costs incurred in thesecond quarter of fiscal year 2004, although legal expenses could increasedepending on developments in our litigation and the occurrence of certainevents outside our control or certain contingent events could require us to payadditional fees to our law firms;

 

•                                          Ourintention to continue seeking to enter into license agreements with UNIXvendors and implementing our worldwide program offering SCOsourceIP licenses to Linux end users;

 

•                                          Ourintention to continue to increase our SCOsource salesefforts in the last two quarters of fiscal year 2004;

 

•                                          Ourexpectation that SCOsource licensing revenue willincrease in the last two quarters of fiscal year 2004 in the form of vendorlicenses and SCOsource IP licenses;

 

•                                          Ouranticipation that for the remainder of fiscal year 2004 our UNIX revenuegenerated in the Americas and the International divisions will be consistentwith or slightly lower than revenue generated in the second quarter of fiscalyear 2004;

 

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

 

•                                          Ourexpectation that our future level of services revenue depends in part on ourability to generate UNIX products revenue from new customers and as well asrenew certain annual support and services agreements with existing UNIXcustomers and our anticipation that ourservices revenue for the last two quarters of fiscal year 2004 to declineslightly from the revenue generated in the second quarter of fiscal year 2004;

 

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•                                          Ourexpectation for the remaining quarters of fiscal year 2004 that our cost ofproducts revenue in dollars will be lower than cost of products revenueincurred in the second quarter of fiscal year 2004;

 

•                                          Ourexpectation for the last two quarters of fiscal year 2004 that our cost of SCOsource licensing revenue will be consistent with ourcost of SCOsource licensing revenue for the secondquarter of fiscal year 2004, subject to quarter-to-quarter fluctuations basedon unpredictable SCOsource licensing revenue, thepossibility that legal expenses could increase depending on developments in ourlitigation,  and the occurrence ofcertain events outside our control or certain contingent events could requireus to pay an additional contingency fee to our law firms;

 

•                                          Ourexpectation for the last two quarters of fiscal year 2004 that our cost ofservices revenue in dollars will be lower than in the second quarter of fiscalyear 2004;

 

•                                          Ourexpectation for the last two quarters of fiscal year 2004 that our sales andmarketing expenses in dollars will decrease from our expenses incurred in thesecond quarter of fiscal year 2004;

 

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

 

•                                          Ourexpectation for the last two quarters of fiscal year 2004 that our general andadministrative expenses in dollars will decrease compared to our general andadministrative expenses incurred in the second quarter of fiscal year 2004 dueto recently implemented cost reductions;

 

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

 

•                                          Ourbelief that we have sufficient cash resources to complete the Series A-1repurchase transaction and fund our current operations for at least the next 12months;

 

•                                          Ourbelief that our allowance and bad debts for accounts receivable will remainconsistent with our prior experience;

 

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

 

•                                          Ourestimation that if we were required to pay cash to redeem BayStar’sSeries A-1 shares pursuant to its redemption notice or otherwise pursuant tothe Certificate of Designation for the Series A-1 shares, it would have amaterial and adverse impact on our liquidity, which may require us to obtainadditional sources of cash to sustain operations.

 

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 other operating systems, particularly Linux, the amount andtiming of SCOsource licensing revenue, our ability toenhance our UNIX operating systems and maintain our UNIX products and servicesbusiness, and the factors set forth in the subsection entitled “RiskFactors” below.  We also wish to advisereaders not to place any undue reliance on the forward-looking statementscontained in this report, which reflect our beliefs and expectations only as ofthe date of this report.  We assume noobligation to update or revise these forward-looking statements to

 

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reflectnew events or circumstances or any changes in our beliefs or expectations,other than as required by law.

 

#### ***RiskFactors***

#### *** ***

*We donot have a history of profitable operations.*

 

Our fiscal year ended October 31, 2003 was thefirst full year we were profitable in our operating history.  Our profitability in fiscal year 2003resulted primarily from our SCOsource licensinginitiatives.  For the six months ended April 30,2004, we incurred a net loss from operations of $14,576,000 and our accumulateddeficit as of April 30, 2004 was $216,583,000.  If we do not receive SCOsourcelicensing revenue in future quarters and our revenue from the sale of our UNIXoperating system platform products and services continues to decline, we willneed to further reduce operating expenses to maintain profitability or generatepositive cash flow.

 

Our UNIX products and services revenue has declined ineach of the last four years primarilyas a result of increased competition from alternative operating systems,particularly Linux, lower information technology spending for UNIX products,and a general overall decline in economic conditions.  In our quarterly results of operations, werecognize revenue from agreements for support and maintenance contracts andother long-term contracts that have been previously invoiced and are includedin deferred revenue.  Our deferredrevenue balance increased from $5,501,000 as of October 31, 2003 to$7,554,000 as of April 30, 2004; however, this increase in deferredrevenue may not continue into future quarters, which may have a negative impacton our UNIX revenue.  Our future UNIXrevenue may be adversely impacted and may continue to decline if we are unableto replenish these deferred revenue balances with long-term maintenance andsupport contracts or replace them with other sustainable revenue streams.  If we are unable to continue to generatepositive cash flow and profitable operations, our operations may be adverselyimpacted.

 

Additionally, on February 5,2004, we completed the exchange transaction in which each outstanding Series Ashare was exchanged for one Series A-1 share, eliminating the derivativerelated to the Series A shares and the charge in our quarterly statements ofoperations for the change in the fair value of the derivative.  We recorded other income of $2,300,000 in thesecond quarter of fiscal year 2004 related to the change in the fair value ofthe derivative between January 31, 2004 and February 5, 2004.  We also recorded a non-cash dividend of$6,305,000 in the second quarter of fiscal year 2004 related to the differencebetween the fair value of the Series A-1 shares and the carrying value of thepreviously issued Series A shares and related derivative.  This dividend will reduce earnings to commonstockholders.

 

*Ourfuture SCOsource licensing revenue is uncertain.*

 

We initiated the SCOsourcelicensing effort in January 2003 to review the status of UNIX licensingand sublicensing agreements.  This effortresulted in the execution of two significant vendor license agreements duringthe fiscal year 2003 and generated $25,846,000 in revenue.  During the three and six months ended April 30,2004, we recorded SCOsource licensing revenue of$11,000 and $31,000, respectively, related to the execution of intellectualproperty compliance licenses.  Due to alack of historical experience and the uncertainties related to SCOsource licensing revenue, we are unable to estimate theamount and timing of future SCOsource licensing revenue,if any.  If we do receive revenue fromthis source, it may be sporadic and fluctuate from quarter to quarter.  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.

 

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*We maynot prevail in our legal actions against IBM, Novell and end users, andunintended consequences of our actions against IBM, Novell and end users andother initiatives to assert our intellectual property rights may adversely affectour business.*

 

We continue to pursue ourlitigation against IBM.  As described inmore detail in Item 1. of Part II of this quarterly report, we seek damages forclaims generally relating to our allegation that IBM has inappropriately usedand distributed our UNIX source code and derivative works in connection withits efforts to promote the Linux operating system.  IBM has responded to our claims and broughtcounterclaims against us asserting generally that we do not have the right toassert claims based on our ownership of UNIX intellectual property against IBMor others in the Linux community. Discovery is continuing in the case, and several motions are currentlypending before the court.  If we do notprevail in our action against IBM, or if IBM is successful in its counterclaimsagainst us, our business and results of operations could be materially harmed.The litigation with IBM and potentially others could be costly, and our costsfor legal fees may be substantial and in excess of amounts for which we havebudgeted. Additionally, the market price of our common stock may be negativelyaffected as a result of developments in our legal action against IBM that maybe, or may be perceived to be, adverse to us.

 

In addition, we havepublicly, and in individual letters, cautioned users of Linux that there areunresolved intellectual property issues surrounding Linux that may expose themto unanticipated liability to us. We have also notified a large number oflicensees under our UNIX contracts requiring them to, among other things,certify they are in compliance with their agreements, including that they arenot using our proprietary UNIX code in Linux, have not allowed unauthorized useof licensed UNIX code by their employees or contractors and have not breachedconfidentiality provisions relating to licensed UNIX code. Additionally, wehave begun notifying selected Linux end users in writing of violations weallege under the Digital Millennium Copyright Act related to our copyrightscontained in Linux.  In concert withthese notification efforts, in March 2004, and we brought suit againstDaimlerChrysler Corporation for its alleged violations of its UNIX softwareagreement with us by failing to certify its compliance with such agreement asrequired by us.  We also brought suitagainst AutoZone, Inc. for its alleged violations of our UNIX copyrightsthrough its use of Linux.  The lawsuitsagainst DaimlerChrysler and AutoZone are also described in more detail in Item1. of Part II of this quarterly report.

 

As a result of our actionagainst IBM, our lawsuits against DaimlerChrysler and AutoZone and our other SCOsource initiatives to protect our intellectual propertyrights, several participants in the Linux industry and others affiliated withIBM or sympathetic to the Linux movement have taken actions attempting tonegatively affect our business and our SCOsourceefforts. Linux proponents have taken a broad range of actions against us,including, for example, attempting to influence participants in the markets inwhich 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 other SCOsource initiatives, and we may lose support from suchparticipants.  Any of the foregoing couldadversely affect our position in the marketplace, our results of operations andour stock price.   We have alsoexperienced several denial-of-service attacks on our website, which haveprevented web users from accessing our website and doing business with us for aperiod of time. If such attacks continue or if our customers and strategicpartners are also subjected to similar attacks, our business and results ofoperations could be materially harmed.

 

Also, some of the moresignificant participants in the Linux industry have made efforts to ease Linuxend users’ concerns that their use of Linux may subject them to potentialcopyright infringement claims from us. For example, Hewlett-Packard, Novell andRed Hat have each established indemnification programs for qualified customerspurchasing Linux-based products and services that may potentially become subjectto a copyright infringement claims from us.

 

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Additionally, Open SourceDevelopment Labs, a non-profit organization (“OSDL”),has established a legal defense fund that will be used to defend Linux usersagainst copyright infringement lawsuits brought by us. It has been reportedthat OSDL so far has attracted several milliondollars in pledges from contributors including IBM and Intel among others.Similarly, Red Hat, Inc. has announced it has committed one milliondollars for a separate fund it created to cover the legal expenses of othercompanies developing Linux.

 

As a further response toour SCOsource initiatives and claim that our UNIXsource code and derivative works have inappropriately been included in Linux,Novell has publicly asserted its belief that it owns certain copyrights in ourUNIX source code, and it has filed 15 copyright applications with the UnitedStates Copyright Office related to UNIX. Novell also claims that it has a license to UNIX from us and the rightto authorize its customers to use UNIX technology in their internal businessoperations.  Specifically, Novell hasalso claimed to have retained rights related to legacy UNIX SVRxlicenses, including the license with IBM. Novell asserts it has the right to take action on behalf of SCO in connection with such licenses, including terminationrights.  Novell has purported to veto ourtermination of the IBM, Sequent and SGI licenses. Wehave repeatedly asserted that we obtained the UNIX business, source code,claims and copyrights when we acquired the assets and operations of the serverand professional services groups from The Santa Cruz Operation (now Tarantella,Inc.) in May 2001, which had previously acquired all such assets and rightsfrom Novell in September 1995 pursuant to an asset purchase agreement, asamended.  In January 2004, inresponse to Novell’s actions, we brought suit against Novell for slander oftitle seeking relief for Novell’s alleged bad faith effort to interfere withour copyrights related to our UNIX source code and derivative works and ourUnixWare products.  Our lawsuit againstNovell is also described in more detail in Item 1. of Part II of this quarterlyreport.

 

Notwithstanding ourassertions of full ownership of UNIX-related intellectual property rights, asset forth above, including copyrights, and even if we are successful in ourlegal action against Novell and end users such as AutoZone and DaimlerChrysler,the efforts of Novell and the other Linux proponents described above may causeLinux end users to be less willing to purchase from us our SCOsourceIP licenses authorizing their use of our intellectual property contained in theLinux operating system, which may adversely affect our revenue from our SCOsource initiatives. These efforts of Linux proponents also may increase the negative viewsome participants in our marketplace have regarding our legal actions againstIBM, Novell and end users such as AutoZone and DaimlerChrysler and regardingour 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 SCOsourceinitiatives and negatively impact our business. Additionally, if we fail in ourlawsuit against Novell and end users such as AutoZone and DaimlerChrysler, thenegative perception and confusion in our marketplace about our intellectualproperty rights and claims likely would increase significantly, and theeffectiveness of our SCOsource initiatives could bematerially harmed.

 

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

 

Our SCOsourceinitiatives, particularly lawsuits against end users violating our intellectualproperty and contractual rights, may cause industry partners, developers andhardware and software vendors to choose not to support or certify to our UNIXoperating system products.  This wouldlead to an accelerated decline in our UNIX products and services revenue andwould adversely impact our results of operations and liquidity.

 

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

 

In August 2003, RedHat brought a lawsuit against us asserting that the Linux operating system doesnot infringe on our UNIX intellectual property rights and seeks a declaratoryjudgment for non-infringement of copyrights and no misappropriation of tradesecrets.  In addition, Red Hat claims wehave engaged in false advertising in violation of the Lanham Act, deceptivetrade practices, unfair competition, tortiousinterference with prospective business opportunities, and trade libel anddisparagement.  We intend to vigorouslydefend this action, but if Red Hat is successful in its claim against us, ourbusiness and results of operations could be materially harmed.

 

In addition, otherregulators or others in the Linux community have initiated or in the future mayinitiate legal actions against us, all of which may negatively impact ouroperations or future operating performance.

 

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

 

Fluctuations in ourquarterly operating results or our failure to meet the expectations of analystsor investors, even in the short-term, could cause our stock price to declinesignificantly. Because of the potential for significant fluctuations in our SCOsource licensing revenue in any particular period, youshould not rely on quarter-to-quarter comparisons of our results of operationsas an indication of future performance.

 

Factors that may affectour results include:

 

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

 

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

 

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

 

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

 

•                                          changesto, or developments in, our ongoing litigation with IBM, Novell, Red Hat,AutoZone and DaimlerChrysler concerning our UNIX intellectual property;

 

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

 

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

 

•                                          changesin attitudes of customers and partners due to our aggressive position againstthe inclusion of our UNIX code and derivative works in Linux and our lawsuits againstend users violating our intellectual property and contractual rights.

 

We also experiencefluctuations in operating results in interim periods in Europe and the AsiaPacific regions due to seasonal slowdowns and economic conditions in theseareas.  Seasonal slowdowns in theseregions typically occur during the summer months.

 

As a result of thefactors listed above and elsewhere, it is possible that our results ofoperations may be below the expectations of public market analysts andinvestors in any particular period. This could cause our stock price todecline. If revenue falls below our expectations and we

 

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are unable to quicklyreduce our spending in response, our operating results will be lower thanexpected. Our stock price may fall in response to these events.

 

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

 

We have a two-tiereddistribution channel. The relationships we have developed with resellers allowus to offer our products and services to a much larger customer base than wewould otherwise be able to reach through our own direct sales and marketingefforts. Some solution providers also purchase solutions through our resellers,and we anticipate they will continue to do so. Because we usually sellindirectly through resellers, we cannot control the relationships through whichresellers, solution providers or equipment integrators purchase ourproducts.  In turn, we do not control thepresentation of our products to end users. Therefore, our sales could beaffected by disruptions in the relationships between us and our resellers, betweenour resellers and solution providers, or between solution providers and endusers. Also, resellers and solution providers may choose not to emphasize ourproducts to their customers. Any of these occurrences could diminish theeffectiveness of our distribution channel and lead to decreased sales.

 

*If themarket for UNIX continues to contract, it may adversely affect our business.*

 

Our revenue from the saleof UNIX products has declined over the last four years. This decrease inrevenue has been attributable primarily to increased competition from otheroperating systems, particularly Linux and lower information technology spendingfor UNIX products. If the demand for UNIX products continues to decline, and weare unable to develop UNIX products and services that successfully address amarket demand, our business will be adversely affected.  Because of the long adoption cycle foroperating system purchases and the long sales cycle of our operating systemproducts, we may not be able to reverse these revenue declines quickly.

 

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

 

In the UNIX operatingsystem market, our competitors include IBM, Hewlett-Packard, Sun, Microsoft andLinux distributors.  These and othercompetitors are aggressively pursuing the current UNIX operating systemmarket.  Many of these competitors have accessto substantially greater resources than we do. The major competitive alternatives to our UNIX products are MicrosoftWindows Server, Linux and other UNIX systems. The expansion of Microsoft’s and our other competitors’ offerings mayrestrict the overall market available for our server products, including somemarkets where we have been successful in the past.

 

Our future success maydepend in part on our ability to continue to meet the increasing needs of ourcustomers by supporting existing and emerging technologies.  If we do not enhance our products to meetthese evolving needs, we may not remain competitive and be able to grow ourbusiness.  Additionally, becausetechnological advancement in the UNIX operating system market and alternativeoperating system markets is at an advanced pace, we will have to develop andintroduce enhancements to our existing products and any new products on atimely basis to keep pace with these developments, evolving industry standardsand changing customer requirements. Our failure to meet any of these and othercompetitive pressures may render our existing products and services obsolete,which would have an adverse impact on our revenue and operations.

 

The success of our UNIXbusiness will depend on the level of commitment and certification we receivefrom industry partners and developers. In recent years, we have seen hardware and software vendors as well assoftware developers turn their certification and application development effortstoward Linux and elect not to continue to support or certify to our UNIXoperating system products.  If this trendcontinues, our competitive position will be adversely

 

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impacted and our futurerevenue from our UNIX business will decline. The decline in our UNIX business may be accelerated if industry partnerswithdraw their support from us 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.

 

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

 

Our compensationarrangement with the law firms representing us in our efforts to establish ourintellectual property rights could inhibit our ability to raise additionalfunding if needed.  In addition toreceiving fees at reduced hourly rates, our agreement with the law firmsprovides that the law firms will receive a contingency fee of 20 percentof the proceeds from specified events related to the protection of ourintellectual property rights.  Theseevents may include settlements, judgments, certain licensing fees, subject tocertain exceptions, and a sale of our company during the pendancyof litigation or through settlement, subject to agreed upon credits for amountsreceived as discounted hourly fees and unused retainer fees, and our agreementwith the law firms may also be construed to include contingency fee payments inconnection with issuances of our equity securities. Future payments payable tothe law firms under this arrangement may be significant. Our law firms’ rightto receive such contingent payments could cause prospective investors to choosenot to invest in our company or limit the price at which new investors would bewilling to provide additional funds to our company.

 

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

 

We have foreignoperations, including development facilities, sales personnel and customersupport operations in Europe, Latin America and Asia.  These foreign operations are subject tocertain inherent risks, including:

 

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

 

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

 

•                                          fluctuationsin currency exchange rates and economic instability;

 

•                                          longerpayment cycles for sales in foreign countries;

 

•                                          seasonalreductions in business activity; and

 

•                                          politicalunrest, particularly in areas where we have facilities.

 

In addition, certain ofour operating expenses are denominated in local currencies, creating risk offoreign currency translation losses that could harm our financial results andcash flows. When we generate profits in foreign countries, our effective incometax rate is increased.

 

In Latin America and Asiain particular, several countries have suffered and may be especiallysusceptible to recessions and economic instability which may lead to increasedgovernmental ownership or regulation of the economy, higher interest rates,increased barriers to entry such as higher tariffs and taxes, and reduceddemand for goods manufactured in the United States, resulting in lower revenue.

 

During the second quarterof fiscal year 2004, the Indian branch of our UK subsidiary was imposed with awithholding tax assessment from the Government of India Income TaxDepartment.  The Tax Department assesseda 15 percent withholding tax on certain revenue transactions in India

 

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that the Tax Departmentdeemed royalty revenue under the Income Tax Act.  We have filed an appeal with the TaxDepartment and believe that our packaged software does not qualify for “royalties”treatment and therefore would not be subject to withholding tax.  However, we may be unsuccessful in our appealagainst the Tax Department and be obligated to pay the assessed taxableamounts.  If other countries in which wehave international operations, such as India, continue to develop and beginenforcing their tax regimes, we may be subject to withholding or other taxes.

 

*Theimpact of domestic and global economic conditions may continue to adverselyimpact our operations.*

 

During the last severalquarters the U.S. and European economies have experienced an economic slowdownthat has affected the purchasing habits of many consumers across manyindustries and across many geographies. This has caused the delay, or even cancellation of, technologypurchases.  The slowdown in the UnitedStates and Europe, together with the alleged unauthorized use of our UNIX code,has resulted in decreased sales of our products, longer sales cycles and lowerprices.  Although the slowdown hasrecently begun to dissipate in the United States and in parts of Europe**,** if such economic improvements are notmaintained and the current slowdown continues or returns, our revenue andresults of operations may continue to be lower than expected.  In addition, a continued slowdown may alsoaffect the end-user market making it more difficult for our reseller channel tosell our products.

 

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

 

We will need to retainour management, technical, and support personnel.  Competition for qualified professionals inthe software industry is intense, and departures of existing personnel could bedisruptive to our business and can result in the departure of other employees.  The loss or departure of any officers or keyemployees could harm our ability to implement our business plan and couldadversely affect our operations.  Ourfuture success depends to a significant extent on the continued service andcoordination of our management team, particularly DarlC. McBride, our President and Chief Executive Officer.  We do not maintain key person insurance forany member of our management team.

 

*Our stockprice is volatile.*

 

The trading price for our common stock has beenvolatile, ranging from a low closing sales price of $1.09 in mid-February 2003,to a sales price of $20.50 per share in October 2003, to a current salesprice of $4.89 on June 10, 2004. The share price has changed dramaticallyover short periods with increases and decreases of over 25 percent in a singleday.  We believe that the changes in ourstock price are affected by changing public perceptions concerning the strengthof our intellectual property claims and other factors beyond our control.  Public perception can change quickly andwithout any change or development in our underlying business or litigationposition.  An investment in our stock issubject to such volatility and, consequently, is subject to significant risk.

 

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

 

As of June 9, 2004,we have issued and outstanding options to purchase up to approximately3,723,000 shares of common stock with exercise prices ranging from $0.66 to$28.00 per share.  The existence of suchrights to acquire common stock at fixed prices may prove a hindrance to ourefforts to raise future equity and debt funding, and the exercise of suchrights will dilute the percentage ownership interest of our stockholders andmay dilute the value of their ownership. The possible future sale of shares issuable onthe exercise of outstanding options could adversely affect the prevailingmarket price for our common stock. Further, the holders of the outstanding rights may exercise them at atime when we would otherwise be able to obtain additional equity capital onterms more favorable to us.

 

*If forany reason we are required to redeem BayStar’s SeriesA-1 shares pursuant to its redemption notice, it would have a material andadverse impact on our liquidity, which may require us to obtain additionalsources of cash to sustain operations.*

 

As stated above in Item 2. of Part I of thisquarterly report, in April 2004, we received a redemption notice from BayStar requesting that we immediately redeem 20,000 sharesof our Series A-1 shares held by BayStar pursuant tothe Certificate of Designation for the Series A-1 shares.  Although we do not believe we are obligatedto redeem BayStar’s Series A-1 shares pursuant to theredemption notice, if we were required to pay cash to redeem BayStar’s Series A-1 shares pursuant to the redemptionnotice or otherwise pursuant to the Certificate of Designation for the SeriesA-1 shares, it would have a material and adverse impact on our liquidity, whichmay require us to obtain additional sources of cash to sustain operations.

 

On May 31, 2004, weentered into an agreement with BayStar to repurchaseand retire BayStar’s 40,000 Series A-1 shares for$13,000,000 in cash and the issuance to BayStar of2,105,263 shares of our common stock. The repurchase transaction will not close unless a registrationstatement covering the resale of the shares of our common stock issuable to BayStar in therepurchase transaction is declared effective by the SEC.  If we fail to cause such registrationstatement to be declared effective, then our repurchase agreement with BayStar may terminate. If the agreement terminates, BayStar mayattempt to enforce its redemption notice, unless it is otherwise rescinded.

 

*BayStar**, as the holder of our outstanding Series A-1 shares,has preferential redemption rights and rights upon liquidation that couldadversely affect the holders of our common stock.*

 

If we fail to completeour Series A-1 share repurchase transaction with BayStarand it remains a holder of Series A-1 shares and otherwise chooses not toconvert them to common stock, then, apart from the redemption notice wereceived from BayStar in April 2004, BayStar would be entitled to require us to repurchase forcash the Series A-1 shares held by it at a premium price if any of severalredemption trigger events occurs as set forth in the Certificate of Designationfor the Series A-1 shares.

 

Additionally, theCertificate of Designation for the Series A-1 shares provides that the numberof shares of our common stock issuable upon theconversion of Series A-1 shares is limited to 2,863,135 shares in theaggregate, notwithstanding that the BayStar mayotherwise be entitled to receive more shares of common stock upon conversionbased on the applicable conversion price. If the number of shares of common stock issuableto BayStar upon conversion is limited in this manner,then we may be required by BayStar to redeem for cashthe number of Series A-1 shares that were not issuableupon conversion as a result of such limits on conversion. If we were requiredto pay cash to BayStar for any reason for its SeriesA-1 shares at a premium price (and other than in connection with the proposedrepurchase transaction), it could have a material impact on our

 

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liquidity, which mayrequire us to obtain additional sources of cash to sustain operations and maynegatively impact the holders of our common stock.

 

Further, BayStar, so long as it remains a holder of Series A-1 shares,will be entitled to receive a preferential distribution of our assets prior toany distribution to our holders of common stock upon a liquidation,dissolution, winding up or other change in control transaction in which we sellall or substantially all our assets or merge or consolidate or otherwisecombine with another company or entity. Upon the occurrence of a liquidationevent, BayStar, as a holder of Series A-1 shares,will be entitled to receive the greater of:

 

•                                          thevalue of the Series A-1 shares held by it determined by multiplying the closingsale price of our common stock on The Nasdaq  SmallCap Market on the date of the liquidation event by thenumber of shares of common stock into which the preferred shares could beconverted at the time of the liquidation event; or

 

•                                          upto $40,000,000, the aggregate purchase price paid for the 40,000 outstandingSeries A-1 shares, plus eight percent of that amount less the amount of anydividends paid to BayStar in the calendar year inwhich the liquidation event occurs.

 

Depending on the amountof assets we have available for distribution to stockholders upon a liquidationevent when Series A-1 shares remain outstanding, we may be required todistribute all such assets or a portion of such assets that exceeds BayStar’s pro rata ownership of our common stock assumingfull conversion of the Series A-1 shares into common stock, which couldeliminate or limit the assets available for distribution to our commonstockholders. Our potential obligation to pay to the law firms representing usin our efforts to establish our intellectual property rights a contingent feeof 20 percent of the proceeds we receive from a sale of our company,subject to certain limitations, could also contribute to eliminating or limitingthe assets available for distribution to our common stockholders.

 

*Therights of BayStar as a holder of Series A-1 sharesmay prevent or make it more difficult for us to raise additional funds or takeother significant company actions.*

 

The Certificate ofDesignation creating our Series A-1 shares requires us to obtain the approvalof BayStar, as the current holder of all outstandingSeries A-1 shares, to take the following actions, among others:

 

•                                          changethe rights, preferences or privileges of the Series A-1 shares or issueadditional Series A-1 shares;

 

•                                          createor issue any other securities that are senior or equal in rank to the SeriesA-1 shares;

 

•                                          createor issue any convertible securities having floating conversion rate terms or afixed conversion price below the then applicable conversion price of the SeriesA-1 shares or the closing sale price of our common stock on The Nasdaq  SmallCap Market on thedate of such issuance;

 

•                                          incurany indebtedness, subject to limited exceptions; or

 

•                                          sellor transfer any material asset or intellectual property to a third party.

 

The Certificate ofDesignation also provides that BayStar, as a holderof Series A-1 shares, has a participation right entitling it to purchase itspro rata share of any future equity securities, or debt that is convertibleinto equity, on the same terms offered by us to other purchasers of suchsecurities.  Additionally, we have agreedwith BayStar that we will not complete a transactionor

 

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take any action thatcould result in a claim for a contingency payment by the law firms representingus in our efforts to establish our intellectual property rights, other thancontingency payments related to certain license transactions, without firstobtaining the consent of BayStar, as it currentlyholds all outstanding Series A-1 shares. This right of consent, and the participation right and other approvalrights described above, may make it more difficult for management, our board ofdirectors or our stockholders to reach a settlement in our litigation with IBM,raise capital in the future in either equity or debt financing transactions orto take other significant company actions. These provisions could also limit the price that some investors might bewilling to pay for shares of our common stock in the future.

 

*TheSeries A-1 shares may have an adverse impact on the market value of our stockand the existing holders of our common stock.*

 

We have an effectiveregistration statement relating to the sale or distribution by BayStar and RBC as sellingstockholders of up to 3,703,704 shares of common stock that are issuable upon conversion of our outstanding Series A-1shares.  We will not receive any proceedsfrom the sales of these shares.  The sharessubject to this registration statement represent approximately 25.8 percent ofour issued and outstanding common stock, although no selling stockholder andits affiliates may beneficially own more than 4.99 percent of our commonstock at any time, and, in the aggregate, no more than 2,863,135 shares of ourcommon stock may be issued upon the conversion of our outstanding Series A-1shares, which number of shares represents 19.99 percent of the number ofshares of our capital stock outstanding as of February 5, 2004, the dateof issuance of our Series A-1 shares. Our Series A-1 shares are convertible into shares of our common stock ata variable price based upon the market price of our common stock, subject to afloor price of $13.50 per share.

 

Additionally, pursuant toour May 31, 2004 stock repurchase agreement with BayStar,we agreed to file a registration statement covering the resale by BayStar as a selling stockholder of the 2,105,263 shares ofcommon stock issuable to BayStaras part of the repurchase.  If thisregistration statement is declared effective by the SEC and we complete therepurchase transaction with BayStar, then we likely will amend thealready-effective registration statement described above to reduce the numberof shares it covers as BayStar will no longer willhold Series A-1 shares that could be converted into shares of common stock issuable upon conversion of Series A-1 shares.  The 2,105,263 shares issuableto BayStar that would be subject to the newregistration statement would represent approximately 12.1 percent of our thenissued and outstanding common stock.

 

The sale of the block ofstock covered by either registration statement, or even the possibility of itssale, may adversely affect the trading market for our common stock and reducethe price available in that market.  Theshares of common stock subject to our registration statements will, uponissuance, dilute the equity ownership percentage of the holders of our commonstock. The market price of our common stock also could decline as a result ofthe perception or expectation that sales of a large number of shares of ourcommon stock could occur following the conversion of our Series A-1shares, ifthe repurchase transaction does not occur.

 

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

 

Our board of directorscurrently has the right, with respect to the 4,920,000 shares of our preferredstock not designated as 80,000 Series A-1 shares, to authorize the issuance ofone or more additional series of our preferred stock with such voting, dividendand other rights as our directors determine. The board of directors can designate new series of preferred stockwithout the approval of the holders of our common stock, subject to theapproval rights of BayStar as the holder of ouroutstanding Series A-1 shares as described above. The rights of holders of ourcommon stock may be adversely affected by the rights of any holders of additionalshares of preferred stock that may be issued in the future, including withoutlimitation, further dilution of the equity ownership

 

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percentage of our holdersof common stock and their voting power if we issue preferred stock with votingrights. Additionally, the issuance of preferred stock could make it moredifficult for a third party to acquire a majority of our outstanding votingstock.

 

*We may have issued shares and options under the Plansthat were not exempt from registration or qualification under federal and statesecurities laws, and, as a result, we may incur liability to repurchase suchshares and options and may face additional potential claims under federal andstate securities laws.*

 

We believe we have issuedcertain shares and granted options under the Plans (as previously defined inPart I, Item 1 of this Amendment No. 1 to Form 10-Q/A) without complying withregistration or qualification requirements under federal securities laws andthe securities laws of certain states. As a result, certain Plan participants that have acquired shares issuedunder the Plans have rescission rights against us, subject to applicablestatutes of limitations, and we may, subject to obtaining required regulatoryapprovals, make a rescission offer to certain of such Plan participants.  Additionally, regulatory authorities mayrequire us to pay fines or they may impose other sanctions on us, and we mayface other claims by Plan participants other than rescission claims.

 

If our potentialrescission offer is made and accepted by Plan participants holding sharesacquired under the Plans or otherwise entitled to recover damages from us inrespect of such shares they have sold, or such Plan participants otherwise makerescission claims against us, we could be liable to make aggregate payments tothese Plan participants of up to $231,000 in the aggregate, excluding interestand other possible fees, based upon shares outstanding under the Plans as of April 30,2004.

 

We may face additionalrescission liability to Plan participants holding unexercised stock options inCalifornia, Georgia and possibly other states and for shares issued inviolation of federal and state securities laws. Additionally, federal securities laws do not provide that a rescissionoffer will terminate a purchaser’s right to rescind a sale of stock that wasnot registered as required, and our possible rescission offer may not terminatea purchaser’s right to rescind a sale of stock that was not registered asrequired under federal laws.  If we donot make the planned rescission offer to all plan participants, or any or allof the offerees reject the rescission offer, we maycontinue to be liable under federal and state securities laws.

 

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

 

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

 

*IBM Corporation*

 

On or about March 6,2003, we filed a complaint against IBM. This action is currently pending in the United States District Court forthe District of Utah, under the title *The SCO Group, Inc. vs. International Business MachinesCorporation*, Civil No. 2:03CV0294. The initial complaint included claims for breach of contract,misappropriation of trade secrets, tortiousinterference, and unfair competition. The original complaint also alleged that IBM obtained informationconcerning the UNIX source code and derivative works from us andinappropriately used and distributed that information in connection with itsefforts to promote the Linux operating system. As a result of IBM’s actions, we are requesting damages in an amount tobe proven at trial, alleged to be approximately $1 billion, together withadditional damages through and after the time of trial.  On or about June 13, 2003, we deliveredto IBM a notice of termination of IBM’s UNIX license agreement with us thatunderlies IBM’s AIX software.

 

On or about June 16,2003, we filed an amended complaint in the IBM case.  The amended complaint essentially restatesand re-alleges the allegations of the original complaint and expands on thoseclaims in several ways.  Mostimportantly, the amended complaint raises

 

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new allegations regardingIBM’s actions and breaches through the products and services of SequentComputer Systems, Inc. (“Sequent”), which IBM acquired.  We allege that our licensing agreement withSequent was breached in several ways similar to those set forth above and weseek damages for those breaches.  We arealso seeking injunctive relief on several claims.

 

IBM has filed a responseand counterclaim to the complaint, including a demand for a jury trial.  We have filed an answer to the IBMcounterclaim denying the claims and asserting affirmative defenses.  On February 4, 2004, we filed a motionfor leave to file amended pleadings in the case proposing to amend ourcomplaint against IBM and to modify our affirmative defenses against IBM’scounterclaims.  On February 25, 2004, the court granted our motion for leave.  The second amended complaint, which was filedon February 27, 2004, alleges nine causes of action that are similar tothose set forth above, adds a new claim for copyright infringement and removesthe claim for misappropriation of trade secrets.  IBM filed an answer and counterclaim.  The counterclaim asserts 14 claims againstus.  In its counterclaim, asamended, IBM asserts that we do not have the right to terminate its UNIXlicense or assert claims based on our ownership of UNIX intellectual propertyagainst them or others in the Linux community. In addition, IBM asserts we have breached the GNU General Public Licenseand have infringed certain patents held by IBM. IBM’s counterclaims includeclaims for breach of contract, violation of the Lanham Act, unfair competition,intentional interference with prospective economic relations, unfair anddeceptive trade practices, promissory estoppel,copyright infringement for a declaratory judgment of non-infringement ofcopyrights, and patent infringement.

 

On March 3, 2004, the U.S. MagistrateJudge issued an order addressing certain discovery matters relating to both ourcompany and IBM.  We have also filed amotion to dismiss IBM’s tenth counterclaim for a declaratory judgment ofnon-infringement of copyrights.  We havealso filed a motion to amend the scheduling order and a motion to bifurcate IBM’spatent counterclaims into another action. We filed, on May 28, 2004, a publicly available reply brief inconnection with our motion to amend the scheduling order, in which we se 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 our motion toamend the scheduling order, with certain changes, and denied IBM’s oppositionto such an amendment.  The amendedscheduling order now provides, among other things, that the deadline forcompleting fact discovery is February 11, 2005 (previously August 4,2004), the deadline for completing expert discovery is April 22, 2005(previously October 22, 2004), and the trial will begin on November 1,2005 (previously April 11, 2005). The court also denied the motion to bifurcate the patent counterclaimswithout prejudice to our right to raise the issue again at a later stage.  IBM has also filed a motion for partialsummary judgment on its tenth counterclaim for a declaration ofnon-infringement.  A hearing regardingour motion to dismiss and IBM’s motion for partial summary judgment on IBM’stenth counterclaim for a declaration of non-infringement is currently scheduledfor August 4, 2004.  Discovery iscontinuing in the IBM case and we plan to vigorously oppose this IBM’s motion.

 

*Red Hat,Inc.*

 

On August 4, 2003, Red Hat filed a complaintagainst us. The action is currently pending in the United States District Courtfor the District of Delaware under the case caption *Red Hat, Inc. v. The SCO Group, Inc.*,Civil No 03-772.  Red Hat asserts thatthe Linux operating system does not infringe our UNIX intellectual propertyrights and seeks a declaratory judgment for non-infringement of copyrights andno misappropriation of trade secrets.  Inaddition, Red Hat claims we have engaged in false advertising in violation ofthe Lanham Act, deceptive trade practices, unfair competition, tortious interference with prospective businessopportunities, trade libel, and disparagement.

 

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On or about September 15,2003, we filed a motion to dismiss the Red Hat complaint.  The motion to dismiss asserts that Red Hat lacksstanding and that no case or controversy exists with respect to the claimsseeking 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. We intend to vigorouslydefend this action.

 

*Novell, Inc.*

 

On January 20, 2004,we filed suit in Utah state court against Novell, Inc. for slander of titleseeking relief for its alleged bad faith effort to interfere with ourcopyrights 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 SCOGroup, Inc. v. Novell, Inc.*,Case No. 040900936.  In the lawsuit, werequested preliminary and permanent injunctive relief as well as damages.  Through these claims we seek to requireNovell to assign to us all copyrights that we believe Novell has wrongfullyregistered, prevent Novell from representing any ownership interest in those copyrightsand require Novell to retract or withdraw all representations it has maderegarding its purported ownership of those copyrights.

 

Novell has not yet answeredour complaint, but has filed with the U.S. District Court for theDistrict of Utah a notice removing the case to such federal court and a motionwith the Third Judicial District Court in Salt Lake County, Utah to transferthe venue of the case from such court to the Fourth Judicial District Court inUtah County, Utah.  Novell also filed amotion to dismiss our complaint claiming it never transferred the copyrights toThe Santa Cruz Operation (now Tarantella, Inc.). We have filed a response toNovell’s motion to dismiss and have also filed a motion to remand the case backto the state court.  On June 10,2004, the court issued a memorandum decision and order which denied our motionto remand the case to state court.  Thememorandum decision also denied Novell’s motion to dismiss in part on claims offalsity.  However, the court grantedNovell’s motion to dismiss regarding our allegations of special damages, butgranted us 30 days leave to amend our complaint to plead special damages withmore specificity.  We plan to continue tovigorously pursue our claims against Novell.

 

*DaimlerChrysler Corporation*

 

On or about March 3,2004, we brought suit against DaimlerChrysler Corporation for its allegedviolations of its UNIX software agreement with us.  Specifically, the lawsuit alleges thatDaimlerChrysler breached its UNIX software agreement with us by failing tocertify by January 31, 2004 its compliance with the UNIX softwareagreement as required by us.  Thelawsuit, filed in Oakland County Circuit Court in the State of Michigan,requests the court to declare that DaimlerChrysler has violated the certificationrequirements of its UNIX software agreement, permanently enjoin DaimlerChryslerfrom further violations of the UNIX software agreement, issue a mandatoryinjunction requiring DaimlerChrysler to remedy the effects of its pastviolations of the UNIX software agreement and award us damages in amount to bedetermined at trial together with costs, attorneys’ fees and any such other ordifferent relief that the Court may deem to be equitable and just.  On April 15, 2004, DaimlerChrysler fileda motion to dismiss our claims.  We arein the process of preparing our response to DaimlerChrysler’s motion and thehearing on this motion is set for July 21, 2004.

 

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*AutoZone, Inc.*

 

On or about March 2,2004, we brought suit against AutoZone, Inc. for its alleged violations of ourUNIX copyrights through its use of Linux. Specifically, the lawsuit alleges that AutoZone is infringing our UNIXcopyrights by, among other things, running versions of the Linux operatingsystem that contain code, structure, sequence and/or organization from ourproprietary UNIX System V code in violation of our copyrights.  The lawsuit filed in U.S. District Court inNevada requests injunctive relief against AutoZone’s further use or copying ofany part of our copyrighted materials and also requests damages as a result ofAutoZone’s infringement in an amount to be proven at trial.  On April 23, 2004, AutoZone filed amotion to transfer the case to Tennessee or to stay the case.  We have filed an opposition to the AutoZonemotion and a hearing is currently scheduled for June 21, 2004 in Nevada.

 

*IPO ClassAction Matter*

 

We are an issuer defendant in a series of class actionlawsuits, involving over 300 issuers that have been consolidated under *In re Initial Public Offering Securities Litigation*,21 MC 92 (SAS). The plaintiffs, the issuers and the insurance companies have negotiateda Memorandum of Understanding (“MOU”) with the intentof settling the dispute between the plaintiffs and the issuers.  We have executed this MOUand have been advised that almost all (if not all) of the issuers have electedto proceed under the MOU.  The terms of the MOUhave been reduced to a settlement agreement that is in the process of beingexecuted by all parties.  This settlementagreement is still subject to court approval. If the settlement is approved by the court, and if no cross-claims,counterclaims or third party claims are later asserted, this action will bedismissed with respect to our directors and us.

 

We have notified our underwriters and insurancecompanies of the existence of the claims. We believe, after consultation with legal counsel, that the ultimateoutcome of this matter will not have a material adverse effect on our resultsof operations or financial position.  Asof January 31, 2004, we have paid or accrued the full retention amount of $200,000under its insurance coverage.

 

*Other Matters*

 

In April 2003, a former Indian distributor ofours filed a claim in India, requesting summary judgment for payment of$1,428,000, and an order that we trade in India only through the distributoruntil the claim is paid. The distributor claims that we are responsible torepurchase certain software products and to reimburse the distributor forcertain other operating costs.  We do notbelieve that we are responsible to reimburse the distributor for any operatingcosts and also believe that the return rights related to any remaininginventory have lapsed.  We have engagedlocal counsel who has advised that it is likely that the current claims willfail, but that the distributor will continue to pursue its claims either in theIndian courts or in the U.S. courts. Discovery has commenced and initial hearings have been held and areongoing.  We intend to vigorously defendthis action.

 

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

 

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**ITEM 2.****                             UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

*Series A and Series A-1 share matters.*

 

On February 5, 2004, we issued 50,000 shares ofour Series A-1 shares in exchange for all then outstanding Series A sharespreviously issued in our October 2003 private placement.  We received no additional proceeds from thisexchange transaction.

 

The Series A-1 shares are convertible into shares ofour common stock at a conversion price equal to the average closing sales priceof our common stock for the ten trading days immediately preceding the date ofconversion, provided that in no event may the conversion price be less than$13.50 (as such conversion price and the $13.50 floor price may be adjusted forstock splits, stock dividends or similar occurrences in the future). Theholders of Series A-1 shares have the right to convert their preferred shares intoshares of common stock any time at their option, provided they convert enoughpreferred shares to receive at least 100,000 shares of common stock and subjectto certain other limitations. Additionally, we may force conversion of theoutstanding Series A-1 shares at any time the market price of our common stockexceeds $24.50 per share (as adjusted for stock splits, stock dividends orsimilar occurrences in the future) for 20 consecutive trading days, providedthat we satisfy certain other requirements. Notwithstanding the foregoing conversion rights, in no event may thenumber of shares of our common stock issuable uponthe conversion of Series A-1 shares exceed (i)2,863,135 shares in the aggregate or (ii) cause any holder of Series A-1 sharesand its affiliates to beneficially own more than 4.99 percent of theoutstanding shares of our common stock, even though the holders thereof mayotherwise be entitled to receive more shares of common stock upon conversionbased on the applicable conversion price.

 

The Series A-1 shares generally has the same rightsthat the Series A shares had, except that the conversion price for the Series Ashares was fixed at $16.93 per share (as adjusted for stock splits, stockdividends or similar occurrences in the future).  Also, the holders of Series A-1 shares havecertain limited voting rights that they did not previously have as holders ofSeries A shares.

 

We issued the unregistered, restricted shares ofSeries A-1 shares in reliance on the exemption from registration provided by Section 3(a)(9)of the Securities Act of 1933, as amended, as a transaction involving theexchange with our then-existing holders of our Series A-1 shares for thepreviously outstanding Series A shares in which no commission or otherremuneration was paid or given directly or indirectly for soliciting suchexchange.

 

On April 1, 2004, following the completion of theexchange of our outstanding Series A shares for Series A-1 shares, after whichno Series A shares remained outstanding, we filed a Certificate of Eliminationwith the Secretary of State of the State of Delaware.  The filing terminated the Certificate ofDesignation, Preference and Rights of our Series A shares, eliminating thepreviously designated Series A shares.

 

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*Repurchases of our common stock.*

 

The following table shows the second quarter of fiscal2004 stock repurchase activity (in thousands, except per share amounts):

 
| ** **         | ** ** | **Total Number of  Shares  Purchased (1)** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Number of  Shares  Purchased as  Part of Publicly  Announced Plan** | ** ** | **Maximum  Number of  Shares that May  Yet to be  Purchased Under  the Plan** | ** ** |
|--------------------|------------|--------------------------------------------|------------|-----------------------------------|------------|-----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
|               |       |                                       |       |                              |       |                                                                        |       |                                                                          |       |
| February 2004 |       | —                                     |       | $                                 | —     |                                                                        | —     |                                                                          | —     |   |
| March 2004    |       | 290                                        |       | 8.27                              |       | 290                                                                         |       | 1,210                                                                         |       |
| April 2004    |       | —                                     |       | —                            |       | —                                                                      |       | 1,210                                                                         |       |
| Total              |       | 290                                        |       | $                                 | 8.27       |                                                                        | 290        |                                                                          |       |   |

 

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(1)          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 ineffect for a period of 24 months from the date announced.

 

*Unregistered sales of shares pursuant to EquityCompensation Plans*

 

As discussed elsewhere above in Part I, Item 1 ofthis Amendment No. 1 to Form 10-Q/A, during the six months ended April 30,2004, we issued shares and granted options under the Plans without complyingwith registration or qualification requirements under federal securities lawsand the securities laws of certain states. As a result, certain Plan participants have a right to rescind theirpurchases of shares under the Plans or recover damages if they no longer ownthe shares or hold unexercised options, subject to applicable statutes oflimitations, and we may make a rescission offer to certain of such Planparticipants subject to obtaining required regulatory approvals.  Additionally, regulatory authorities mayrequire us to pay fines or they may impose other sanctions on us, and we mayface other claims by Plan participants other than rescission claims.

 

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

 

The following matterswere submitted and approved by our stockholders at our annual meeting held April 20,2004:

 

1.                                       Toelect eight members to the Board of Directors to serve until their successorshave been appointed. All seven directors were elected with Ralph J. Yarro III receiving 11,319,000 votes in favor and 423,000votes withheld, Thomas P. Raimondi, Jr. receiving11,618,000 votes in favor and 125,000 votes withheld; Edward E. Iacobucci receiving 11,138,000 votes in favor and 605,000votes withheld; Daniel W. Campbell receiving 11,682,000 votes in favor and60,000 votes withheld; R. Duff Thompson receiving 11,627,000 votes in favor and115,000 votes withheld; Darcy G. Mott receiving 11,324,000 votes in favor and418,000 votes withheld; K. Fred Skousen receiving11,682,000 votes in favor and 60,000 votes withheld; and DarlC. McBride receiving 11,679,000 votes in favor and 63,000 votes withheld.

 

2.                                       Toapprove the 2004 Omnibus Stock Incentive Plan and to provide for up to1,500,000 shares of common stock to be subject to awards issued under theplan.  This resolution was passed with6,254,000 votes in favor, 760,000 votes against and 474,000 abstentions.

 

3.                                       Toapprove the appointment of KPMG LLP as ourindependent public accountants for the year ending October 31, 2004.  This resolution was passed with 11,711,000votes in favor, 19,000 votes against and 13,000 abstentions.

 

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**ITEM 6.****                             EXHIBITSAND REPORTS ON FORM 8-K**

 

(a)                                 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   |   | Letter Amending Engagement Agreement dated November 17,  2003 from Darl C. McBride, President and Chief  Executive Officer of SCO, to David Boies of Boies, Schiller &  Flexner LLP (incorporated by reference to Exhibit  99.2 to SCO’s Current Report on Form 8-K filed on December 9,  2003 (File No. 000-29911)). |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.2   |   | Letter Agreement dated December 8, 2003 among SCO, BayStar Capital II, L.P.,  Royal Bank of Canada and Boies, Schiller &  Flexner LLP (incorporated by reference to Exhibit  99.3 to SCO’s Current Report on Form 8-K filed on December 9,  2003 (File No. 000-29911)).                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.3   |   | Exchange Agreement dated as of February 5, 2004  among SCO, BayStar  Capital II, L.P. and Royal Bank of Canada (incorporated by reference to  Exhibit 99.1 to SCO’s Current Report on Form 8-K  filed on February 9, 2004 (File No. 000-29911)).                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 31.1   |   | Certification of Darl C. McBride, President and Chief Executive Officer,  pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 31.2   |   | Certification of Bert  B. Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of the Exchange  Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 32.1   |   | Certification of Darl C. McBride, President and Chief Executive Officer,  pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 32.2   |   | Certification of Bert  B. Young, Chief Financial Officer, pursuant to Section 1350, Chapter 63  of Title 18, United States Code, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                                                                                        |

 

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(b)                   Reports on Form 8-K

 

On February 9,2004, we filed a current report on Form 8-K announcing we had completed anExchange Agreement with the investors in our October 2003 Series AConvertible Preferred Stock financing.

 

On March 3,2004, we filed a current report on Form 8-K announcing our financial resultsfor the three months ended January 31, 2004.

 

On March 3,2004, we filed a current report on Form 8-K announcing we had taken legalaction against AutoZone, Inc. and DaimlerChrysler Corporation.

 

On March 5,2004, we filed a current report on Form 8-K announcing we had received an orderto compel discovery in our lawsuit against IBM.

 

On March 11,2004, we filed a current report on Form 8-K announcing we had implemented astock buyback program.

 

On April 16,2004, we filed a current report on Form 8-K announcing we had received aredemption notice from BayStar Capital II, L.P.

 

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

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

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

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                                                                                  |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                               |
| 3.1                 |       | Amended and Restated  Certificate of Incorporation of Caldera International, Inc. (incorporated by  reference to Exhibit 3.1 to SCO’s Registration  Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 3.2                 |       | Certificate of  Amendment to Amended and Restated Certificate of Incorporation regarding  consolidation of outstanding shares (incorporated by reference to Exhibit 3.2  to SCO’s Registration Statement on Form 8-A12G/A  (File No. 000-29911)).                                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 3.3                 |       | Certificate of  Amendment to Amended and Restated Certificate of Incorporation regarding  change of name to The SCO Group, Inc. (incorporated  by reference to Exhibit 3.3 to SCO’s Registration  Statement on Form 8A12G/A (File No. 000-29911)).                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 3.4                 |       | Amended and Restated  Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s  Registration Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 3.5                 |       | Certificate of  Designation for Series A-1 Convertible Preferred Stock (incorporated by  reference to Exhibit 4.1 to SCO’s Current Report on  Form 8-K filed on February 9, 2004 (File No. 000-29911)).                                                                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 3.6                 |       | Certificate of  Correction correcting the Certificate of Designation for Series A-1  Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to SCO’s Current Report on Form 8-K filed on February 9,  2004 (File No. 000-29911)).                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 10.1                |       | Letter Amending Engagement Agreement dated November 17,  2003 from Darl C. McBride, President and Chief  Executive Officer of SCO, to David Boies of Boies, Schiller &  Flexner LLP (incorporated by reference to Exhibit  99.2 to SCO’s Current Report on Form 8-K filed on December 9,  2003 (File No. 000-29911)). |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 10.2                |       | Letter Agreement dated December 8, 2003 among SCO, BayStar Capital II, L.P.,  Royal Bank of Canada and Boies, Schiller &  Flexner LLP (incorporated by reference to Exhibit  99.3 to SCO’s Current Report on Form 8-K filed on December 9,  2003 (File No. 000-29911)).                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 10.3                |       | Exchange Agreement dated as of February 5, 2004  among SCO, BayStar  Capital II, L.P. and Royal Bank of Canada (incorporated by reference to  Exhibit 99.1 to SCO’s Current Report on Form 8-K  filed on February 9, 2004 (File No. 000-29911)).                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 31.1                |       | Certification of Darl C. McBride, President and Chief Executive Officer,  pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                                     |
| 31.2                |       | Certification of Bert  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.                                                                                                         |

 

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

 

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