**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q/A**

 

**Amendment No. 1**

 

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

 

**For the transition period from              to              **

 

**Commission file number 0-29911**

 

**THE SCO GROUP, INC.**

(Exact name of registrant as specified in itscharter)

 
| **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 andzip code)

 

**(801) 765-4999**

(Registrant’s telephone number, including areacode)

 

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 duringthe preceding 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)

 

YES o  NO ý

 

As of March 10,2004, there were 14,414,606 shares of the Registrant’s common stock, $0.001 parvalue per share, outstanding.

 

 

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**Explanatory Note**

 

The purpose of this Amendment No. 1 to theQuarterly Report on Form 10-Q/A is to restate the Company’s condensedconsolidated financial statements for the three months ended January 31,2004 (the “Financial Statements”) and to modify the related disclosures.  Please see Note 2 to the Financial Statementsincluded in the amended Form 10-Q.

 

The restatement arose from the Company’sdetermination that it has issued certain shares of its common stock under itsequity compensation plans without complying with the registration requirementsof 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 SeriesA Convertible Preferred Stock and the recording of stock-basedcompensation.  The Company will alsoreclassify an amount from cash and cash equivalents to available-for-salesecurities to reflect the appropriate classification of certain auction ratesecurities.

 

This amended Form 10-Q/Adoes not attempt to modify or update any other disclosures set forth in theoriginal Form 10-Q, except as required to reflect the effects of therestatement as described in Note 2 to the Financial Statements included in theamended Form 10-Q/A. Additionally, this amended Form 10-Q/A, except for therestatement information, speaks as of the filing date of the original Form 10-Qand does not update or discuss any other Company developments after the date ofthe original 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 SCO Group, Inc.**

 

**Tableof Contents**

 
| PART I.  |   | FINANCIAL INFORMATION                                                                                                              |   |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.  |   | Financial Statements                                                                                                               |   |
|     |   | Condensed  Consolidated Balance Sheets as of January 31, 2004 and October 31,  2003                                      |   |
|     |   | Condensed  Consolidated Statements of Operations and Comprehensive Loss for the three  months ended January 31, 2004 and 2003 |   |
|     |   | Condensed  Consolidated Statements of Cash Flows for the three months ended January 31,  2004 and 2003                        |   |
|     |   | Notes  to Condensed Consolidated Financial Statements                                                                              |   |
| Item  2. |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                        |   |
| Item  3. |   | Quantitative  and Qualitative Disclosures About Market Risk                                                                        |   |
| Item 4.  |   | Controls and Procedures                                                                                                            |   |
|     |   | Forward-Looking Statements                                                                                                         |   |
|     |   | Risk  Factors                                                                                                                      |   |
| PART II. |   | OTHER INFORMATION                                                                                                                  |   |
| Item 1.  |   | Legal Proceedings                                                                                                                  |   |
| Item  2. |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                       |   |
| Item 6.  |   | Exhibits and Reports  on Form 8-K                                                                                                  |   |
| Item 7.  |   | Signatures                                                                                                                         |   |

 

3

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(unaudited,in thousands)**

 
| *** ***                                                                                                             | *** *** | **January 31,  2004**   | ** ** | **October 31,  2003** | *** *** |
|--------------------------------------------------------------------------------------------------------------------------|--------------|------------------------------|------------|----------------------------|--------------|
| *** ***                                                                                                             | *** *** | **(Restated -  see Note 2)** | ** ** | ** **                 | *** *** |
| **ASSETS**                                                                                                               | ** **   | ** **                   | ** ** | ** **                 | ** **   |
|                                                                                                                     |         |                         |       |                       |         |
| CURRENT  ASSETS:                                                                                                         |         |                         |       |                       |         |
| Cash and  cash equivalents                                                                                               |         | $                            | 46,991     |                       | $            | 64,428 |   |
| Restricted  cash                                                                                                         |         | 550                          |       | 2,025                      |         |
| Available-for-sale  securities                                                                                           |         | 17,716                       |       | 4,095                      |         |
| Accounts  receivable, net of allowance for doubtful accounts of $231 and $230,  respectively                             |         | 9,151                        |       | 9,282                      |         |
| Other current  assets                                                                                                    |         | 1,864                        |       | 2,450                      |         |
| Total  current assets                                                                                                    |         | 76,272                       |       | 82,280                     |         |
|                                                                                                                     |         |                         |       |                       |         |
| PROPERTY AND  EQUIPMENT:                                                                                                 |         |                         |       |                       |         |
| Computer and  office equipment                                                                                           |         | 3,658                        |       | 3,482                      |         |
| Leasehold  improvements                                                                                                  |         | 626                          |       | 608                        |         |
| Furniture  and fixtures                                                                                                  |         | 206                          |       | 189                        |         |
|                                                                                                                     |         | 4,490                        |       | 4,279                      |         |
| Less accumulated  depreciation and amortization                                                                          |         | (3,439                       | )          | (3,131                     | )            |
| Net property  and equipment                                                                                              |         | 1,051                        |       | 1,148                      |         |
|                                                                                                                     |         |                         |       |                       |         |
| OTHER  ASSETS:                                                                                                           |         |                         |       |                       |         |
| Goodwill                                                                                                                 |         | 1,166                        |       | 1,166                      |         |
| Intangibles,  net                                                                                                        |         | 8,415                        |       | 9,286                      |         |
| Other  assets, net                                                                                                       |         | 1,311                        |       | 1,072                      |         |
| Total other  assets                                                                                                      |         | 10,892                       |       | 11,524                     |         |
|                                                                                                                     |         |                         |       |                       |         |
| Total assets                                                                                                             |         | $                            | 88,215     |                       | $            | 94,952 |   |
|                                                                                                                     |         |                         |       |                       |         |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                           | ** **   | ** **                   | ** ** | ** **                 | ** **   |
|                                                                                                                     |         |                         |       |                       |         |
| CURRENT  LIABILITIES:                                                                                                    |         |                         |       |                       |         |
| Accounts  payable                                                                                                        |         | $                            | 1,418      |                       | $            | 1,978 |   |
| Royalty  payable to Novell, Inc.                                                                                         |         | 550                          |       | 2,025                      |         |
| Accrued compensation  to law firms                                                                                       |         | 7,956                        |       | 10,556                     |         |
| Accrued  payroll and benefits                                                                                            |         | 3,583                        |       | 4,752                      |         |
| Accrued  liabilities                                                                                                     |         | 6,488                        |       | 3,754                      |         |
| Derivative  related to redeemable convertible preferred stock                                                            |         | 11,600                       |       | 15,224                     |         |
| Deferred  revenue                                                                                                        |         | 6,952                        |       | 5,501                      |         |
| Other  royalties payable                                                                                                 |         | 308                          |       | 523                        |         |
| Taxes  payable                                                                                                           |         | 966                          |       | 799                        |         |
| Total  current liabilities                                                                                               |         | 39,821                       |       | 45,112                     |         |
|                                                                                                                     |         |                         |       |                       |         |
| LONG-TERM  LIABILITIES                                                                                                   |         | 578                          |       | 508                        |         |
|                                                                                                                     |         |                         |       |                       |         |
| MINORITY  INTEREST                                                                                                       |         | 145                          |       | 145                        |         |
|                                                                                                                     |         |                         |       |                       |         |
| COMMITMENTS  AND CONTINGENCIES (Note 6)                                                                                  |         |                         |       |                       |         |
|                                                                                                                     |         |                         |       |                       |         |
| SERIES A  REDEEMABLE CONVERTIBLE PREFERRED STOCK, $0.001 par value, 50 and 50 shares  outstanding, respectively (Note 7) |         | 29,671                       |       | 29,671                     |         |
|                                                                                                                     |         |                         |       |                       |         |
| COMMON STOCK  SUBJECT TO RESCISSION (Note 8)                                                                             |         | 272                          |       | —                     |         |
|                                                                                                                     |         |                         |       |                       |         |
| STOCKHOLDERS’  EQUITY:                                                                                              |         |                         |       |                       |         |
| Common  stock, $0.001 par value; 45,000 shares authorized, 14,340 and 13,824 shares  outstanding, respectively           |         | 14                           |       | 14                         |         |
| Additional  paid-in capital                                                                                              |         | 218,531                      |       | 218,690                    |         |
| Warrants  outstanding                                                                                                    |         | 1,099                        |       | 1,099                      |         |
| Deferred  compensation                                                                                                   |         | (237                         | )          | (347                       | )            |
| Accumulated  other comprehensive income                                                                                  |         | 917                          |       | 926                        |         |
| Accumulated  deficit                                                                                                     |         | (202,596                     | )          | (200,866                   | )            |
| Total  stockholders’ equity                                                                                         |         | 17,728                       |       | 19,516                     |         |
|                                                                                                                     |         |                         |       |                       |         |
| Total  liabilities and stockholders’ equity                                                                         |         | $                            | 88,215     |                       | $            | 94,952 |   |

 

See notes to condensedconsolidated financial statements.

 

4

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ANDCOMPREHENSIVE LOSS**

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

 
|                                                                                                | *** *** | **Three Months Ended January 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|--------------|-----------------------------------------|------------|
|                                                                                                | *** *** | **2004**                                | ** ** | **2003** | ** ** |
|                                                                                                | *** *** | **(Restated -  see Note 2)**            | ** ** | ** ** | ** ** |
| REVENUE:                                                                                            |         |                                    |       |   |   |
| Products                                                                                            |         | $                                       | 9,712      |   | $ | 11,090 |   |
| SCOsource  licensing                                                                                |         | 20                                      |       | — |   |
| Services                                                                                            |         | 1,660                                   |       | 2,450 |   |
| Total  revenue                                                                                      |         | 11,392                                  |       | 13,540 |   |
|                                                                                                |         |                                    |       |   |   |
| COST OF  REVENUE:                                                                                   |         |                                    |       |   |   |
| Products                                                                                            |         | 888                                     |       | 1,186 |   |
| SCOsource  licensing                                                                                |         | 3,440                                   |       | — |   |
| Services                                                                                            |         | 1,322                                   |       | 1,692 |   |
| Total cost  of revenue                                                                              |         | 5,650                                   |       | 2,878 |   |
|                                                                                                |         |                                    |       |   |   |
| GROSS MARGIN                                                                                        |         | 5,742                                   |       | 10,662 |   |
|                                                                                                |         |                                    |       |   |   |
| OPERATING  EXPENSES:                                                                                |         |                                    |       |   |   |
| Sales and  marketing (exclusive of stock-based compensation of $18 and $34,  respectively)          |         | 5,021                                   |       | 6,440 |   |
| Research and  development (exclusive of stock-based compensation of $12 and $23,  respectively)     |         | 2,707                                   |       | 2,650 |   |
| General and  administrative (exclusive of stock-based compensation of $405 and $155,  respectively) |         | 2,194                                   |       | 1,650 |   |
| Restructuring  charges (reversals)                                                                  |         | —                                  |       | (252 | ) |
| Amortization  of intangibles                                                                        |         | 787                                     |       | 700 |   |
| Stock-based  compensation                                                                           |         | 435                                     |       | 212 |   |
| Total  operating expenses                                                                           |         | 11,144                                  |       | 11,400 |   |
|                                                                                                |         |                                    |       |   |   |
| LOSS FROM  OPERATIONS                                                                               |         | (5,402                                  | )          | (738 | ) |
|                                                                                                |         |                                    |       |   |   |
| EQUITY IN  INCOME (LOSSES) OF AFFILIATES                                                            |         | 37                                      |       | (25 | ) |
|                                                                                                |         |                                    |       |   |   |
| OTHER INCOME  (EXPENSE):                                                                            |         |                                    |       |   |   |
| Interest  income                                                                                    |         | 270                                     |       | 39 |   |
| Change in  fair value of derivative (Note 7)                                                        |         | 3,624                                   |       | — |   |
| Other income  (expense), net                                                                        |         | (131                                    | )          | 5 |   |
| Total other  income, net                                                                            |         | 3,763                                   |       | 44 |   |
|                                                                                                |         |                                    |       |   |   |
| LOSS BEFORE  INCOME TAXES                                                                           |         | (1,602                                  | )          | (719 | ) |
|                                                                                                |         |                                    |       |   |   |
| PROVISION  FOR INCOME TAXES                                                                         |         | (128                                    | )          | (5 | ) |
|                                                                                                |         |                                    |       |   |   |
| NET LOSS                                                                                            |         | (1,730                                  | )          | (724 | ) |
|                                                                                                |         |                                    |       |   |   |
| DIVIDENDS ON  SERIES A REDEEMABLE CONVERTIBLE PREFERRED STOCK                                       |         | (756                                    | )          | — |   |
|                                                                                                |         |                                    |       |   |   |
| NET LOSS  APPLICABLE TO COMMON STOCKHOLDERS                                                         |         | $                                       | (2,486     | ) | $ | (724 | ) |
|                                                                                                |         |                                    |       |   |   |
| BASIC AND  DILUTED NET LOSS PER COMMON SHARE                                                        |         | $                                       | (0.18      | ) | $ | (0.06 | ) |
|                                                                                                |         |                                    |       |   |   |
| WEIGHTED  AVERAGE BASIC AND DILUTED COMMON SHARES OUTSTANDING                                       |         | 13,824                                  |       | 11,244 |   |
|                                                                                                |         |                                    |       |   |   |
| OTHER  COMPREHENSIVE LOSS                                                                           |         |                                    |       |   |   |
| Net loss                                                                                            |         | $                                       | (1,730     | ) | $ | (724 | ) |
| Unrealized  loss on available-for-sale securities                                                   |         | (19                                     | )          | — |   |
| Foreign  currency translation adjustment                                                            |         | 10                                      |       | 157 |   |
| COMPREHENSIVE  LOSS                                                                                 |         | $                                       | (1,739     | ) | $ | (567 | ) |

 

See notes to condensedconsolidated financial statements.

 

5

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited,in thousands)**

 
|                                                                               | *** *** | **Three Months Ended January 31,** | *** *** |
|------------------------------------------------------------------------------------|--------------|-----------------------------------------|--------------|
|                                                                               | *** *** | **2004**                                | ** **   | **2003** | *** *** |
|                                                                               | *** *** | **(Restated -  see Note 2)**            | ** **   | ** ** | *** *** |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                             |         |                                    |         |   |   |
| Net loss                                                                           |         | $                                       | (1,730       | ) | $ | (724 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:       |         |                                    |         |   |   |
| Change in  fair value of derivative                                                |         | (3,624                                  | )            | — |   |
| Amortization  of intangibles (including $84 and $85 classified as cost of revenue) |         | 871                                     |         | 785 |   |
| Depreciation  and other amortization                                               |         | 252                                     |         | 341 |   |
| Stock-based  compensation                                                          |         | 435                                     |         | 212 |   |
| Equity in  (income) losses of affiliates                                           |         | (37                                     | )            | 25 |   |
| Changes in  operating assets and liabilities                                       |         |                                    |         |   |   |
| Accounts  receivable, net                                                          |         | 131                                     |         | (867 | ) |
| Other  current assets                                                              |         | 586                                     |         | 1,906 |   |
| Other assets                                                                       |         | (202                                    | )            | (94 | ) |
| Accounts  payable                                                                  |         | (560                                    | )            | (416 | ) |
| Accrued  payroll and benefits                                                      |         | (1,169                                  | )            | (1,046 | ) |
| Accrued  compensation to law firms                                                 |         | (2,600                                  | )            | — |   |
| Accrued  liabilities                                                               |         | 1,855                                   |         | (1,022 | ) |
| Deferred  revenue                                                                  |         | 1,451                                   |         | (254 | ) |
| Other  royalties payable                                                           |         | (215                                    | )            | (68 | ) |
| Taxes  payable                                                                     |         | 167                                     |         | (191 | ) |
| Long-term  liabilities                                                             |         | 70                                      |         | (195 | ) |
| Net cash  used in operating activities                                             |         | (4,319                                  | )            | (1,608 | ) |
|                                                                               |         |                                    |         |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                             |         |                                    |         |   |   |
| Purchase of  property and equipment                                                |         | (131                                    | )            | (17 | ) |
| Purchase of  available-for-sale securities                                         |         | (14,989                                 | )            | — |   |
| Proceeds  from available-for-sale securities                                       |         | 1,368                                   |         | — |   |
| Investment  in non-marketable securities                                           |         | —                                  |         | (350 | ) |
| Net cash  used in investing activities                                             |         | (13,752                                 | )            | (367 | ) |
|                                                                               |         |                                    |         |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                             |         |                                    |         |   |   |
| Proceeds  from sale of common stock through ESPP                                   |         | 370                                     |         | 57 |   |
| Proceeds  from exercise of common stock options                                    |         | 297                                     |         | 124 |   |
| Net cash  provided by financing activities                                         |         | 667                                     |         | 181 |   |
|                                                                               |         |                                    |         |   |   |
| NET DECREASE  IN CASH AND CASH EQUIVALENTS                                         |         | (17,404                                 | )            | (1,794 | ) |
| EFFECT OF FOREIGN  EXCHANGE RATES ON CASH                                          |         | (33                                     | )            | 147 |   |
| CASH AND  CASH EQUIVALENTS, beginning of period                                    |         | 64,428                                  |         | 6,589 |   |
| CASH AND  CASH EQUIVALENTS, end of period                                          |         | $                                       | 46,991       |   | $ | 4,942 |   |
|                                                                               |         |                                    |         |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                 |         |                                    |         |   |   |
|                                                                               |         |                                    |         |   |   |
| Cash paid  for taxes                                                               |         | $                                       | 67           |   | $ | 129 |   |
|                                                                               |         |                                    |         |   |   |
| SUPPLEMENTAL  SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:         |         |                                    |         |   |   |
|                                                                               |         |                                    |         |   |   |
| Accretion of  dividends                                                            |         | $                                       | 756          |   | $ | — |   |
|                                                                               |         |                                    |         |   |   |
| Common stock  subject to rescission                                                |         | $                                       | 272          |   | $ | — |   |

 

See notes to condensed consolidatedfinancial statements.

 

6

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**THE SCO GROUP, INC. ANDSUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

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

 

The Company was originally incorporated asCaldera Systems, Inc. (“Caldera Systems”), a Utah corporation, on August 21,1998, and reincorporated as a Delaware corporation on March 6, 2000.

 

OnMay 7, 2001, Caldera International, Inc. (“Caldera”) was formed as a holdingcompany to own Caldera Systems and to acquire substantially all of the assets,liabilities and operations of the server and professional services groups ofThe Santa Cruz Operation, now known as Tarantella, Inc., pursuant to anAgreement and Plan of Reorganization (the “Reorganization Agreement”), dated asof August 1, 2000, as amended. Under the Reorganization Agreement, Caldera acquired the tangible andintangible assets used in the server and professional services groups,including all of the capital stock of certain of The Santa Cruz Operation’ssubsidiaries.  In connection with theformation of Caldera, Caldera Systems became a wholly-owned subsidiary ofCaldera.  All shares of Caldera Systems’common stock, as well as options to purchase shares of Caldera Systems’ commonstock, were converted into the same number of shares of common stock of Calderaand options to purchase shares of common stock of Caldera.

 

Theacquired operations from The Santa Cruz Operation developed and marketed serversoftware related to networked business computing and were one of the leadingproviders of UNIX server operating systems. In addition, these operations provided professional services related toimplementing and maintaining UNIX system software products.  The acquisition provided Caldera withinternational offices and a distribution channel with resellers throughout theworld.  Subsequent to this acquisition,the Company has primarily sold UNIX based products and services.

 

OnMay 16, 2003, Caldera’s stockholders approved an amendment to Caldera’scertificate of incorporation that changed Caldera’s name to The SCO Group, Inc.(the “Company”).

 

TheCompany’s business focuses on marketing reliable, cost-effective UNIX softwareproducts and related services for the small-to-medium sized businessmarket.  In January 2003, theCompany established its SCOsource division and launched its first of severalSCOsource initiatives to review and enforce its intellectual propertysurrounding the UNIX operating system. The Company acquired the intellectualproperty rights surrounding UNIX and UNIX System V source code from The SantaCruz Operation.

 

**(2) RESTATEMENT OF FINANCIAL STATEMENTS**

 

The Company’s previously issued condensedconsolidated financial statements for the three months ended January 31,2004 have been restated to correct the accounting for the following items:

 

•                  Reclassifying$879,000 of accrued dividends from equity to current liabilities related to theCompany’s outstanding shares of Series A Convertible Preferred Stock.  The accrued dividends had previously beenrecorded incorrectly in equity.  Theaccrued dividends were never paid and were properly captured in the calculationof earnings per share in the periods above;

 

7

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•                  Reclassifyingfrom permanent equity to temporary equity $272,000 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 $272,000 in the aggregate, excluding interest andother possible fees was based upon shares outstanding as of January 31,2004; and

 

•                  Recordingin the first quarter of fiscal year 2004 stock-based compensation of $233,000incurred by issuing an equity award to a consultant which previously had beenrecorded in the Company’s condensed consolidated financial statements for thesecond quarter of fiscal year 2004.

 

In addition to the above restatement items,the Company has made a reclassification of $10,954,000 from cash and cashequivalents to available-for-sale securities to reflect the appropriateclassification of certain auction rate securities as the original maturity ofthese securities is greater than three months.

 

The following table summarizes the effect ofthe restatement and reclassification adjustments on the Financial Statements asof and for the three months ended January 31, 2004 (in thousands, exceptper share amounts):

 
|                                         |   | **Three Months Ended January 31,** | *** *** |
|----------------------------------------------|--------|-----------------------------------------|--------------|
|                                         |   | **2004**                                | ** **   | **2004** | *** *** |
|                                         |   | **(Previously  Reported)**              | ** **   | **(Restated)** | *** *** |
| Stock-based  compensation                    |   | $                                       | 202          |   | $ | 435 |   |
| Total  operating expenses                    |   | 10,911                                  |         | 11,144 |   |
| Loss from  operations                        |   | (5,169                                  | )            | (5,402 | ) |
| Loss before  income taxes                    |   | (1,369                                  | )            | (1,602 | ) |
| Net loss                                     |   | (1,497                                  | )            | (1,730 | ) |
| Net loss  applicable to common stockholders  |   | (2,253                                  | )            | (2,486 | ) |
| Basic and  diluted net loss per common share |   | $                                       | (0.16        | ) | $ | (0.18 | ) |
|                                         |   |                                    |         |   |   |
| Net cash  used in investing activities       |   | (2,798                                  | )            | (13,752 | ) |

 

8

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|                                |   | **As of January 31,** | *** *** |
|-------------------------------------|--------|----------------------------|--------------|
|                                |   | **2004**                   | ** **   | **2004** | *** *** |
|                                |   | **(Previously  Reported)** | ** **   | **(Restated)** | *** *** |
| Cash and  equivalents               |   | $                          | 57,945       |   | $ | 46,991 |   |
| Available-for-sale  securities      |   | 6,762                      |         | 17,716 |   |
| Accrued  liabilities                |   | 5,609                      |         | 6,488 |   |
| Total  current liabilities          |   | 38,942                     |         | 39,821 |   |
| Common stock  subject to rescission |   | —                     |         | 272 |   |
| Additional  paid-in capital         |   | 219,449                    |         | 218,531 |   |
| Accumulated  deficit                |   | (202,363                   | )            | (202,596 | ) |
| Total  stockholders’ equity    |   | 18,879                     |         | 17,728 |   |
|                                     |        |                            |              |  |  |  |  |

 

The Company’s previously issued notes tocondensed consolidated financial statements for the three months ended January 31,2004 have been restated to correct the accounting for the following item:

 

•                  Restatingthe pro forma fair value of stock-based compensation in the notes to condensedconsolidated financial statements by $304,000 to appropriately include the fairvalue of certain equity awards that were not correctly included in the originaldisclosure.

 

The following table summarizes the effect ofthis restatement adjustment on the notes to condensed consolidated financialstatements as of and for the three months ended January 31, 2004 (inthousands, except per share amounts):

 
|                                                                  | ** ** | **Three Months Ended January 31,** | *** *** |
|-----------------------------------------------------------------------|------------|-----------------------------------------|--------------|
|                                                                  | ** ** | **2004**                                | ** **   | **2004** | *** *** |
|                                                                  | ** ** | **(Previously  Reported)**              | ** **   | **(Restated)** | *** *** |
| Net loss  applicable to common stockholders:                          |       |                                    |         |   |   |
| As reported                                                           |       | $                                       | (2,253       | ) | $ | (2,486 | ) |
| Stock-based  compensation as reported                                 |       | 202                                     |         | 435 |   |
| Stock-based  compensation under fair value method                     |       | (503                                    | )            | (807 | ) |
| Pro forma  net loss                                                   |       | $                                       | (2,554       | ) | $ | (2,858 | ) |
|                                                                  |       |                                    |         |   |   |
| Net loss  applicable to common stockholders per diluted common share: |       |                                    |         |   |   |
| As reported                                                           |       | $                                       | (0.16        | ) | $ | (0.18 | ) |
| Pro forma                                                             |       | $                                       | (0.18        | ) | $ | (0.21 | ) |

 

## **(3) SIGNIFICANT ACCOUNTING POLICIES**

 

### **Basisof Presentation**

 

The accompanyingunaudited condensed consolidated financial statements of the Company have beenprepared by the Company pursuant to the rules and regulations of the Securitiesand Exchange Commission (“SEC”) on a basis consistent with the Company’saudited annual financial statements, and, in the opinion of management, reflectall adjustments, consisting

 

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of normal recurringadjustments, necessary to present fairly the financial information set forththerein.  Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to SEC rules andregulations, although the 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.

 

### **Useof Estimates in the Preparation of Financial Statements**

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during the reportingperiod.  Actual results could differ fromthese estimates.  The Company’s criticalaccounting policies and estimates, as discussed in the Company’s most recentannual report on Form 10-K, include, among others, revenue recognition,allowances for doubtful accounts receivable, determination of fair value of thederivative associated with the Company’s previously issued shares of redeemableSeries A Convertible Preferred Stock, impairment of long-lived assets, andvaluation allowances against deferred income tax assets.

 

### **RevenueRecognition**

 

The Company recognizesrevenue in accordance with Statement of Position (“SOP”) 97-2, as modified bySOP 98-9 and Staff Accounting Bulletin (“SAB”) No. 104.  Revenue recognition in accordance with thesepronouncements can be complex due to the nature and variability of the Company’ssales transactions.  The Company’srevenue is primarily from three sources: (i) product license revenue, primarilyfrom product sales to distributors and end users, and royalty revenue fromproduct sales by source code original equipment manufacturers (“OEMs”); (ii)service and support revenue, primarily from providing support and education andconsulting services to end users; and (iii) licensing revenue from itsSCOsource intellectual property initiative.

 

The Company recognizesproduct revenue upon shipment if a signed contract exists, the fee is fixed anddeterminable, collection of the resulting receivable is probable and productreturns are reasonably estimable, except for sales to distributors, which arerecognized upon sale by the distributor to end users.

 

The majority of theCompany’s revenue transactions relate to product-only sales.  On occasion, the Company has revenuetransactions that have multiple elements (i.e., delivered and undeliveredproducts, maintenance and other services). For software agreements that have multiple elements, the Companyallocates revenue to each component of the contract based on the relative fairvalue of the elements.  The fair value ofeach element is based on vendor specific objective evidence (“VSOE”).  VSOE is established when such elements aresold separately.  The Company recognizesrevenue allocated to undelivered products when the criteria for product revenuerecognition set forth above have been met. If VSOE of all undelivered elements exists, but VSOE does not exist forone or more delivered elements, then revenue is recognized using the residualmethod.  Under the residual method, thefair value of the undelivered elements is

 

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deferred and recognizedin future periods and the remaining portion of the license fee is recognized inthe current period as product revenue.

 

The Company recognizesproduct revenue from OEM’s upon receipt of sales-out royalty reports andrecognizes revenue from maintenance fees for ongoing customer support ratablyover the period of the maintenance contract. Payments for maintenance fees are generally made in advance and are non-refundable.  Revenue from education and consultingservices is recognized as the related services are performed.

 

The Company’s SCOsourcelicensing revenue to date has been generated from license agreements to utilizethe Company’s UNIX source code as well as from intellectual property compliancelicenses.  The Company recognizes revenuefrom SCOsource licensing agreements when a signed contract exists, the fee isfixed and determinable, collection of the receivable is probable and deliveryhas occurred.  If the payment termsextend beyond the Company’s normal payment terms, revenue is recognized as thepayments are received.

 

**Hedgingof Foreign Currency Transactions**

 

The Company utilizesforeign currency forward exchange contracts to hedge foreign currency marketexposures of underlying assets and liabilities. The Company does not use forward exchange contracts for speculative ortrading purposes.  The Company’saccounting policies for these instruments are based on the Company’sdesignation of such instruments as hedging transactions.  The criteria the Company uses for designatingan instrument as a hedge include the instrument’s effectiveness in riskreduction and one-to-one matching of forward exchange contracts to underlyingtransactions.  Gains and losses oncurrency forward contracts that are designated and effective as hedges of firmcommitments are deferred and recognized in income in the same period that theunderlying transactions are settled. Gains and losses on currency forward contracts that are designated andeffective as hedges of existing transactions are recognized in income in thesame period as losses and gains on the underlying transactions are recognizedand generally offset.  Gains and losseson any instruments not meeting the above criteria are recognized in income inthe current period.  As of January 31,2004, the Company had one foreign exchange contract with a maturity ofapproximately 30 days to sell an aggregate of 650,000 United Kingdom pounds forapproximately $1,170,000 U.S. dollars. As of January 31, 2004, the Company had no outstanding instrumentsaccounted for as hedges.

 

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

 

The Company considersall highly liquid debt instruments purchased with original maturities of threeor fewer months to be cash equivalents. Cash and cash equivalents were approximately $46,991,000 as of January 31,2004, which primarily consisted of investments in money market funds andcommercial paper.

 

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The following table shows the cost, realized gain or loss and fair marketvalue of the Company’s cash equivalents and available-for-sale securities as ofJanuary 31, 2004 (in thousands):

 
|                      |   | **Cost** | ** ** | **Realized Gains  (Losses)** | ** ** | **Fair Market  Value** | *** *** |
|---------------------------|--------|----------|------------|------------------------------|------------|------------------------|--------------|
|                      |   |     |       |                         |       |                   |         |
| Commercial  paper         |   | $        | 40,261     |                         | $          | 10                     |         | $ | 40,271 |   |
| Corporate  notes          |   | 14,594   |       | (5                           | )          | 14,589                 |         |
| Money market              |   | 1,335    |       | —                       |       | 1,335                  |         |
| U.S.  Government agencies |   | 4,881    |       | (1                           | )          | 4,880                  |         |
| Total                     |   | $        | 61,071     |                         | $          | 4                      |         | $ | 61,075 |   |

 

Available-for-salesecurities as of January 31, 2004 included government agencies, corporatenotes, money market funds, and corporate debt. Available-for-sale securities are recorded at fair market value, basedon quoted market prices, and unrealized gains and losses are recorded as acomponent of comprehensive income (loss). Realized gains and losses, which are calculated based on thespecific-identification method, are recorded in operations as incurred.  As of January 31, 2004,available-for-sale securities consisted of the following maturities (inthousands):

 
|                |   | **2004**   | *** *** |
|---------------------|--------|------------|--------------|
| Maturity date       |   | ** ** | *** *** |
| 3 – 6 months   |   | $          | —       |   |
| 6 – 12  months |   | 1,446      |         |
| > 12  months     |   | 16,270     |         |
| Total               |   | $          | 17,716       |   |

 

**Net Income (Loss) per CommonShare**

 

Basic net income (loss)per common share (“Basic EPS”) is computed by dividing net income (loss) by theweighted average number of common shares outstanding.  Diluted net income (loss) per common share (“DilutedEPS”) is computed by dividing net income (loss) by the sum of the weightedaverage number of common shares outstanding and the dilutive potential commonshare equivalents then outstanding. Potential common share equivalents consist of the weighted average ofshares issuable upon the exercise of outstanding stock options, restrictedstock awards, issued shares of redeemable Series A Convertible Preferred Stockand warrants to acquire common stock.

 

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The following table is areconciliation of the numerator and denominator of Basic EPS to the numeratorand denominator of Diluted EPS (in thousands, except per share amounts):

 
|                                             |   | **Three Months Ended January 31,** | *** *** |
|--------------------------------------------------|--------|-----------------------------------------|--------------|
|                                             |   | **2004**                                | ** **   | **2003** | *** *** |
|                                             |   | **(restated)**                          | ** **   | ** ** | *** *** |
| Numerator:                                       |   |                                    |         |   |   |
| Net loss  applicable to common stockholders      |   | $                                       | (2,486       | ) | $ | (724 | ) |
|                                             |   |                                    |         |   |   |
| Denominator:                                     |   |                                    |         |   |   |
| Weighted  average common shares outstanding      |   | 13,824                                  |         | 11,244 |   |
|                                             |   |                                    |         |   |   |
| Basic and  diluted EPS                           |   | $                                       | (0.18        | ) | $ | (0.06 | ) |
|                                             |   |                                    |         |   |   |
| Excluded  anti-dilutive common share equivalents |   | 6,548                                   |         | 3,986 |   |

 

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

 

The Company accounts forstock options issued to directors, officers and employees under AccountingPrinciples Board (“APB”) No. 25.  UnderAPB No. 25, compensation expense is recognized if an option’s exercise price onthe measurement date is below the fair market value of the Company’s commonstock.

 

Statements of FinancialAccounting Standards (“SFAS”) No. 148, “Accounting for Stock-BasedCompensation,” requires pro forma information regarding net income (loss) as if the Company hadaccounted for its stock 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.

 

Withrespect to stock options, restricted stock awards granted and employee stockpurchase program (“ESPP”) shares purchased during the three months ended January 31,2004 and 2003, the assumptions used are listed in the following table: 

 
|                               |   | **Three Months Ended January 31,** | *** *** |
|------------------------------------|--------|-----------------------------------------|--------------|
|                               |   | **2004**                                | ** **   | **2003** | *** *** |
| Risk-free  interest rate           |   | 2.4                                     | %            | 2.2 | % |
| Expected  dividend yield           |   | 0.0                                     | %            | 0.0 | % |
| Volatility                         |   | 73.4                                    | %            | 81.9 | % |
| Expected  exercise life (in years) |   | 3.1                                     |         | 3.3 |   |

 

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Forpurposes of the pro forma disclosure, the estimated fair value of the stockoptions, restricted stock awards and ESPP shares are amortized over the vestingperiod of the award.  The following isthe pro forma disclosure and the related impact on net loss and the net lossper diluted common share for the three months ended January 31, 2004 and2003 (in thousands, except per share amounts):****

 
|                                                                  |   | **Three Months Ended January 31,** | *** *** |
|-----------------------------------------------------------------------|--------|-----------------------------------------|--------------|
|                                                                  |   | **2004**                                | ** **   | **2003** | *** *** |
|                                                                  |   | **(restated)**                          | ** **   | ** ** | *** *** |
| Net loss  applicable to common stockholders:                          |   |                                    |         |   |   |
| As reported                                                           |   | $                                       | (2,486       | ) | $ | (724 | ) |
| Stock-based  compensation as reported                                 |   | 435                                     |         | 212 |   |
| Stock-based  compensation under fair value method                     |   | (807                                    | )            | (678 | ) |
| Pro forma  net loss                                                   |   | $                                       | (2,858       | ) | $ | (1,190 | ) |
|                                                                  |   |                                    |         |   |   |
| Net loss  applicable to common stockholders per diluted common share: |   |                                    |         |   |   |
| As reported                                                           |   | $                                       | (0.18        | ) | $ | (0.06 | ) |
| Pro forma                                                             |   | $                                       | (0.21        | ) | $ | (0.11 | ) |

 

**(4)INTANGIBLE ASSETS**

 

In July 2001, theFinancial Accounting Standards Board issued SFAS No. 142, “Goodwill and OtherIntangible Assets.”  Under SFAS No. 142,goodwill and other intangible assets with indefinite lives are no longeramortized, but rather are assessed annually for impairment.  The Company adopted SFAS No. 142 on November 1,2001, the beginning of fiscal year 2002. All of the Company’s identifiable intangible assets are deemed to havefinite lives and are amortized over their remaining useful lives.

 

Upon adoption of SFAS142, the Company reassessed the useful lives of its intangible assets.  The following table summarizes the componentsof amortized intangible assets and their useful lives as of January 31,2004 (in thousands):

 
|                            | ** ** | **Estimated  Useful Life** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** |   |
|---------------------------------|------------|----------------------------|------------|-----------------------------|------------|-------------------------------|------------|---------------------|--------|
| Amortizable  intangible assets: |       |                       |       |                        |       |                          |       |                |   |
| Distribution/reseller  channel  |       | 5 years                    |       | $                           | 11,626     |                          | $          | 5,252               |   | $ | 6,374 |   |
| Acquired  technology            |       | 5 years                    |       | 1,687                       |       | 761                           |       | 926                 |   |
| Acquired  technology            |       | 2 years                    |       | 1,555                       |       | 583                           |       | 972                 |   |
| Trade name                      |       | 5 years                    |       | 262                         |       | 119                           |       | 143                 |   |
| Total  intangible assets        |       |                       |       | $                           | 15,130     |                          | $          | 6,715               |   | $ | 8,415 |   |

 

The carrying amount ofgoodwill as of January 31, 2004 was $1,166,000 related to the Company’sacquisition of substantially all the assets of Vultus, Inc., a web servicesbusiness, in fiscal year 2003.  TheCompany performed an impairment analysis as of January 31, 2004 inaccordance with SFAS No. 142, and determined that the goodwill reported in theaccompanying condensed consolidated balance sheets was not impaired.  However, events and circumstances may changein future periods that may require to the Company to record an impairmentcharge related to the goodwill.

 

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**(5)RESTRUCTURING PLANS**

 

The Company’s board ofdirectors has adopted restructuring plans to reduce facilities andpersonnel.  These restructuring planshave resulted in the Company recording restructuring accruals for the costsassociated with the reduction in facilities and for severance costs of affectedemployees.  There were no restructuringactivities undertaken during the three months ended January 31, 2004.  The following table summarizes the activityrelated to the restructuring accruals during the three months ended January 31,2004 (in thousands):

 
|       | ** ** | **Balance as of  October 31,  2003** | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **Utilization** | ** ** | **Balance as of  January 31,  2004** | ** ** |
|------------|------------|-------------------------------------------|------------|---------------|------------|-----------------|------------|-----------------|------------|-------------------------------------------|------------|
|       |       |                                      |       |          |       |            |       |            |       |                                      |       |
| Facilities |       | $                                         | 348        |          | $          | —          |       | $               | —     |                                      | $          | (53 | ) | $ | 295 |   |
|            |            |                                           |            |               |            |                 |            |                 |            |                                           |            |  |  |  |  |  |

 

The remainingrestructuring accrual relates to costs associated with one facility that hasfuture lease payments extending through June 2005.

 

**(6) COMMITMENTS AND CONTINGENCIES**

 

**Litigation**

 

*IBMCorporation*

 

On or about March 6, 2003, the Company filed a complaint againstIBM Corporation (“IBM”).  The action iscurrently pending in the United States District Court for the District ofUtah.  The complaint includes claims forbreach of contract, misappropriation of trade secrets, tortious interference,and unfair competition.  The complaintalso alleges that IBM obtained information concerning the UNIX source code andderivative works from the Company and inappropriately used and distributed thatinformation in connection with its efforts to promote the Linux operatingsystem.  As a result of IBM’s breach ofcontract and unfair competition and the marketplace injury sustained by theCompany, it is requesting damages in an amount to be proven at trial, but noless than $1 billion, together with additional damages through and after thetime of trial.  On or about June 13,2003, the Company delivered to IBM a notice of termination of IBM’s UNIXlicense agreement with the Company, which license underlies IBM’s AIX software.

 

On or about June 16, 2003, the Companyfiled an amended complaint in the IBM case. The amended complaint essentially restates and realleges the allegationsof the original complaint and expands on those claims.  Most importantly, the amended complaintraises new allegations regarding IBM’s actions and breaches through the actionsof Sequent Computer Systems, Inc. (“Sequent”), which IBM acquired.  The Company alleges that the Sequentagreement was breached in several ways similar to those set forth above and itseeks damages flowing from those breaches. The Company also seeks injunctive relief on several of its claims.

 

IBM has filed a response and counterclaim to the complaint, including ademand for a jury trial.  The Company hasfiled an answer to the IBM counterclaim denying the claims and assertingaffirmative defenses.  In itscounterclaim, as amended on September 25, 2003, IBM asserts that the Companydoes not have the right to terminate IBM’s UNIX license or assert claims basedon the Company’s ownership of UNIX intellectual property against IBM or othersin the Linux community.  In addition, IBMasserts that the Company has breached the GNU General

 

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Public Licenseand has infringed certain patents held by IBM. IBM’s counterclaims include claims for breach of contract, violation ofthe Lanham Act, unfair competition, intentional interference with prospectiveeconomic relations, unfair and deceptive trade practices, breach of the GNUgeneral public license and patent infringement. Discovery is ongoing in the case. The Company intends to vigorously defend these counterclaims.

 

On February 4, 2004, the Company filed a motion for leave to fileamended pleadings in the case proposing to amend its complaint against IBM andto modify its affirmative defenses against IBM’s counterclaims.  On February 25, 2004, the court grantedthe Company’s motion for leave.  Thesecond amended complaint, which was filed on February 27, 2004, allegesnine causes of action that are similar to those set forth above, adds a newclaim for copyright infringement and removes the claim for misappropriation oftrade secrets.  IBM has not yet respondedto the second amended complaint.

 

*Red Hat, Inc.*

 

On or about August 4,2003, Red Hat, Inc. (“Red Hat”) filed a complaint against the Company in theUnited States District Court for the District of Delaware.  Red Hat asserts that the Linux operatingsystem does not infringe on the Company’s UNIX intellectual property rights andseeks a declaratory judgment for non-infringement of copyrights and nomisappropriation of trade secrets.  Inaddition, Red Hat claims the Company has engaged in false advertising inviolation of the Lanham Act, deceptive trade practices, unfair competition,tortious interference with prospective business opportunities, trade libel anddisparagement.

 

On or about September 15,2003, the Company filed a motion to dismiss the Red Hat complaint.  The motion to dismiss asserts that Red Hatlacks standing and that no case or controversy exists with respect to theclaims seeking a declaratory judgment of non-infringement.  The motion to dismiss further asserts thatRed Hat’s claims under the Lanham Act and related state laws are barred by theFirst Amendment to the U.S. Constitution and the common law privilege ofjudicial immunity.  Red Hat has filed anopposition to the Company’s motion to dismiss, but the court has not ruled onthe motion.  The Company intends tovigorously defend this action.

 

*Novell, Inc.*

 

On or about January 20, 2004,the Company brought suit against Novell, Inc. for slander of title seekingrelief for Novell’s alleged bad faith efforts to interfere with the Company’scopyrights related to its UNIX source code and derivative works and itsUnixWare product.  In the lawsuit, theCompany requested preliminary and permanent injunctive relief as well asdamages.  The injunction would requireNovell to assign to the Company all copyrights that it believes Novell haswrongfully registered, prevent Novell from representing any ownership interestin those copyrights and require Novell to retract or withdraw allrepresentations it has made regarding its purported ownership of thosecopyrights.  Novell has not yet answeredthe Company’s complaint but has filed with the United States District Court forthe District of Utah a notice removing the case to such federal court and amotion with the Third Judicial District Court in Salt Lake County, Utah totransfer the venue of the case from such court to the Fourth Judicial DistrictCourt in Utah County, Utah.  Neithercourt has ruled on these actions.  Novellalso filed a motion to dismiss the Company’s complaint claiming it nevertransferred the copyrights to The Santa Cruz Operation.  The Company has filed a response to Novell’smotion to dismiss and has also filed a motion to

 

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remand the case back tothe state court.  The court has not ruledon these motions.  The Company plans tovigorously pursue its claims against Novell.

 

*IPO Matter*

 

The Company is an issuer defendant in a series of class action lawsuitsinvolving over 300 issuers that have been consolidated under one action.  The consolidated complaint alleges amongother things, certain improprieties regarding the underwriters’ conduct duringthe Company’s initial public offering and the failure to disclose such conductin the registration statement in violation of the Securities Act of 1933, asamended.

 

The plaintiffs, the issuers and the insurance companies have negotiateda Memorandum of Understanding (“MOU”) with the intent of settling the disputebetween the plaintiffs and the issuers. The Company has executed this MOU and has been advised that almost all(if not all) of the issuers have elected to proceed under the MOU.  The MOU is still subject to court approvaland the preparation of appropriate settlement documents.  If the settlement is approved by the courtand settlement agreements can be entered into by the parties, and if nocross-claims, counterclaims or third party claims are later asserted, thisaction will be dismissed with respect to the Company and its individuals.

 

The Company has notified its underwriters and insurance companies ofthe existence of the claims.  Managementbelieves, after consultation with legal counsel, that the ultimate outcome ofthis matter will not have a material adverse effect on the Company’s results ofoperations or financial position.  As of January 31,2004, the Company has paid or accrued the full retention amount of $200,000under its insurance coverage.

 

*OtherMatters*

 

In April 2003, a former Indian distributor of the Company filed aclaim in India, requesting summary judgment for payment of $1,428,000, and anorder that the Company trade in India only through the distributor until theclaim is paid. The distributor claims that the Company is responsible torepurchase certain software products and to reimburse the distributor forcertain other operating costs. Management does not believe that the Company is responsible to reimbursethe distributor for any operating costs and also believes that the returnrights related to any remaining inventory have lapsed.  Management has engaged local counsel who hasadvised that it is likely that the current claims will fail, but that thedistributor will continue to pursue its claims either in the Indian courts orin the U.S. courts.  Discovery hascommenced and initial hearings have been held and are ongoing.  The Company intends to vigorously defend thisaction.

 

Pursuit and defense of the above-mentioned matters will be costly, andmanagement expects the costs for legal fees and related expenses may besubstantial.  The ultimate outcome orpotential effect of the Company’s results of operations or financial positionas a result of the above-mentioned matters is not currently known ordeterminable.

 

The Company is a party to certain other legal proceedings arising inthe ordinary course of business including legal proceedings arising from itsSCOsource initiative.  Managementbelieves, after consultation with legal counsel, that the ultimate outcome ofsuch legal

 

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proceedings willnot have a material adverse effect on the Company’s results of operations orfinancial position.

 

**Arrangement with Law Firms**

 

On or about February 26,2003, the Company entered into an arrangement with Boies, Schiller &Flexner LLP and other firms to investigate and review the Company’s UNIXintellectual property rights.  Thisarrangement was later modified on November 17, 2003 and December 8,2003.  The engagement with the law firmsnow includes the defense work related to counter suits and other retaliatoryactions against the Company and lawsuits against end users violating theCompany’s intellectual property and contractual rights.  The law firms are also representing theCompany in its lawsuits against IBM and Novell and in the end user lawsuits describedbelow in Note 10.

 

In addition to receivingfees at reduced hourly rates, the Company’s agreement with the law firmsprovides that the law firms will receive a contingency fee of 20 percent of theproceeds from specified events related to the protection of the Company’sintellectual property rights.  Theseevents may include settlements, judgments, licensing fees, subject to certainexceptions, and a sale of the Company during the pendancy of litigation orthrough settlement, subject to agreed upon credits for amounts received asdiscounted hourly fees and unused retainer fees.  Additionally, the Company’s agreement withthe law firms may also be construed to include contingency fee payments inconnection with the Company’s issuance of equity securities.  Future payments payable to the law firmsunder this arrangement may be significant.

 

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

 

The Company believescertain shares and options granted under its 1998 Stock Option Plan, 1999Omnibus Stock Incentive Plan, 2002 Omnibus Stock Incentive Plan and 2004Omnibus Stock Incentive Plan and shares under its 2000 Employee Stock PurchasePlan (collectively, the “Plans”) were issued without complying with registrationor qualification requirements under federal securities laws and the securitieslaws of certain states.  As a result,certain Plan participants have a right to rescind their purchases of sharesunder the 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.

 

The Company believescertain of its stock option grants made since February 2003 may have alsoviolated applicable state securities laws even though holders have notexercised such options.  Although theCompany is continuing to evaluate its potential rescission risk to optionholders, the Company is considering making a rescission offer to certain optionholders.  Because the options in questionhave not been exercised, 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.

 

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The Company believesthat it is reasonably possible that some option holders may accept a rescissionoffer, but the Company is unable to estimate the number of participants whomight accept a rescission offer and the amount of potential damages that itwould be required to pay under a rescission offer.  Since any loss is considered reasonablypossible but not estimable, the Company has not recorded a liability for thiscontingency.

 

The Company may also berequired to pay interest and penalties up to statutory limits in connectionwith Plan participants making rescission claims or in connection with anyrescission offer.  The Company believesthat it is reasonably possible that it may be required to pay interest andpenalties, but it is not able to estimate an amount.

 

**(7)  REDEEMABLE SERIES A CONVERTIBLE PREFERREDSTOCK**

 

On October 16, 2003,the Company issued 50,000 shares of its redeemable Series A ConvertiblePreferred Stock (the “Series A”) for $1,000 per share.  The net proceeds from the sale of the SeriesA were $47,740,000.  The value of theSeries A is classified outside of permanent equity because of certainredemption features that are outside the control of the Company.  As described in Note 10, on February 5,2004, all outstanding Series A shares were exchanged for shares of the Company’sredeemable Series A-1 Convertible Preferred Stock and, as a result, no Series Ashares remain outstanding as of February 5, 2004.

 

The terms of the SeriesA include a number of redemption provisions that represent a derivativefinancial instrument under SFAS No. 133, “Accounting for Derivative Instrumentsand Hedging Activities.”  The Companydetermined that the conversion feature to allow the holders of the Series A toacquire common shares was an embedded derivative that does not qualify as ascope exemption under the provisions of EITF 00-19, “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in a Company’s OwnStock.”  This required the Company torecord at fair value and mark-to-market the fair value of the derivative.  Changes in the fair value of the derivativeare recorded in the Company’s statement of operations.  As of October 16, 2003, the Company,through the assistance of an independent valuation firm, determined the initialfair value of the derivative was $18,069,000. As of October 31, 2003, the fair value of the derivative was$15,224,000 and the decrease in fair value of $2,845,000 was recorded as otherincome in the statement of operations for fiscal year 2003.

 

As of January 31,2004, the fair value of the derivative was $11,600,000, and the decrease infair value of $3,624,000 was recorded as other income in the statement ofoperations for three months ended January 31, 2004.  Assumptions used to value the derivative asof January 31, 2004 included a term of three years, fair value of commonstock of $14.37 and an interest rate for similar securities of 15 percent.

 

Dividends will be paidafter the first anniversary of the closing and will be paid quarterly at a rateof 8 percent per annum, subject to annual increases of 2 percent per annum, notto exceed 12 percent per annum.  TheCompany has the option of paying dividends in cash or shares of the Series A,subject to certain limitations.  Becausedividends are not payable during the first year the Series A is outstanding,the Company has accrued dividends of $756,000 for three months ended January 31,2004, which reduced earnings to common stockholders.  These dividends are in addition to $123,000in accrued dividends recorded in fiscal year 2003 and are recorded as acomponent of accrued liabilities as of January 31, 2004.

 

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Subject to certainlimitations, each holder of the Series A will have the right to convert, at theoption of the holder, at any time, into shares of the Company’s common stock ata stated conversion price of $16.93 per share, subject to stock splits, stockdividends or other occurrences.  TheCompany has the ability to force conversion of the Series A at any time theCompany’s common stock price exceeds 150 percent of the then prevailingconversion price per share for 20 consecutive trading days, provided theCompany satisfies certain other requirements.

 

The Company was requiredto file a registration statement on Form S-3 covering the resale of the sharesof common stock issuable upon conversion of the Series A.  This registration statement was declaredeffective by the Securities and Exchange Commission on February 25, 2004.

 

**(8) COMMON STOCK SUBJECT TORESCISSION**

 

The Company believescertain shares and options granted under the Plans were issued withoutcomplying with registration or qualification requirements under federalsecurities 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.

 

Accounting SeriesRelease (“ASR”) No. 268 and Emerging Issues task Force (“EITF”) Topic D-98requires that stock subject to rescission or redemption requirements outsidethe control of the Company to be classified outside of permanent equity.  Theexercise of rescission rights are at the holders’ discretion, but whether theyexercise such rights may depend in part on the fair value of the Company’scommon stock, which is outside of the Company’s and the holders’ control.  Consequently, common stock subject torescission is classified as temporary equity. If the Company’s possible rescission offer is made and accepted by Planparticipants holding shares acquired under the Plans or otherwise entitled torecover damages from the Company in respect of such shares they have sold, orsuch Plan participants otherwise make rescission claims against the Company,the Company could be liable to make aggregate payments to these Planparticipants of up to $272,000 in the aggregate, excluding interest and otherpossible fees, based upon shares outstanding under the Plans as of January 31,2004.

 

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

 

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**(9) STOCKHOLDERS’ EQUITY**

 

**Stock-Based Compensation**

 

The following tabledetails the components of stock-based compensation for the three months ended January 31,2004 and 2003 (in thousands):

 
|                                      |   | **Three Months Ended January 31,** |       |
|-------------------------------------------|--------|-----------------------------------------|------------|
|                                      |   | **2004**                                | ** ** | **2003** |   |
|                                      |   | **(restated)**                          | ** ** | ** ** |   |
| Amortization  of stock-based compensation |   | $                                       | 110        |   | $ | 156 |   |
| Options and  shares for services          |   | 233                                     |       | 56 |   |
| Modifications  to options                 |   | 92                                      |       | — |   |
| Total                                     |   | $                                       | 435        |   | $ | 212 |   |

 

During the three monthsended January 31, 2004, the Company granted options to purchase 49,000shares of common stock with an average exercise price of $16.08 per share.  None of these stock options was granted withan exercise price below the quoted market price on the date of grant.  During the three months ended January 31,2004, options to purchase approximately 175,000 shares of common stock wereexercised with an average exercise price of $1.69 per share.  As of January 31, 2004, there wereapproximately 3,505,000 stock options outstanding with a weighted averageexercise price of $3.98 per share.

 

During the quarter endedJanuary 31, 2004, the Company modified an option grant to one of its boardmembers.  The Company recognizedcompensation expense of approximately $92,000 related to the modification ofthis option.

 

In December 2002,the Company issued an option to acquire 50,000 shares of the Company’s commonstock at $1.52 per share to a consultant for services.  The options vest upon the achievement ofcertain milestones.  The fair value ofthe options is expensed in the period the milestones are achieved.  The final milestone for 15,000 options wasachieved during the three months ended January 31, 2004 and the Companyrecorded $233,000 of expense related to this option.

 

**EmployeeStock Purchase Plan**

 

The 2000 Employee StockPurchase Plan, as amended, was adopted by the board of directors on February 15,2000 and was approved by the stockholders on March 1, 2000.  The plan is designed to allow eligible employeesof the Company and its participating subsidiaries to purchase shares of theCompany’s common stock, at semi-annual intervals, through periodic payrolldeductions.  A participant may contributeup to 10 percent of his or her cash earnings through payroll deductions and theaccumulated payroll deductions will be applied to the purchase of shares on theparticipant’s behalf on each semi-annual purchase date (the last business dayin May and November).  The purchase priceper share will be 85 percent of the lower of the fair market value of theCompany’s common stock on the participant’s entry date into the offering periodor the fair market value on the semi-annual purchase date.

 

The Company’s board ofdirectors may at any time amend or modify the plan.  The plan will terminate no later than thelast business day in April 2010.

 

On November 28,2003, employees participating in the Company’s employee stock purchase planacquired approximately 341,000 shares of the Company’s common stock at anaverage purchase price of $1.09 per share.

 

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**(10) SIGNIFICANT CUSTOMERS**

 

During the three monthsended January 31, 2004, Tech Data Corporation accounted for approximately10 percent of total revenue.  During thethree months ended January 31, 2003, the Company did not have anycustomers that accounted for more than 10 percent of total revenue.

 

**(11) SEGMENT INFORMATION**

 

The Company’s resourcesare allocated and operating results managed to the operating income (loss)level for each of the Company’s two geographic units for its UNIX division andthe Company’s SCOsource licensing division. The geographic units for the UNIX division consist of the Americasdivision and the International division. The revenue, cost of revenue and direct sales and marketing expenses aretracked for each division.  The costs ofcorporate sales and marketing, research and development and general andadministration are allocated to each division based on that divisions’percentage of total revenue.  Thecorporate revenue and expenses include amounts not directly attributable to aspecific division.

 

Segment disclosures forthe Company’s operating divisions are as follows for the three months ended January 31,2004 and 2003 (in thousands):

 
|                        | ** ** | **Three Months Ended January 31,  2004 (restated)** | *** *** |
|-----------------------------|------------|----------------------------------------------------------|--------------|
|                        | ** ** | **Americas**                                             | ** **   | **International** | ** ** | **SCOsource** | ** ** | **Corporate** | ** ** | **Total** | *** *** |
|                        |       |                                                     |         |   |   |   |   |   |   |   |   |
| Revenue                     |       | $                                                        | 6,763        |   | $ | 4,673 |   | $ | 20 |   | $ | (64 | ) | $ | 11,392 |   |
| Cost of  revenue            |       | 1,370                                                    |         | 818 |   | 3,440 |   | 22 |   | 5,650 |   |
| Gross margin                |       | 5,393                                                    |         | 3,855 |   | (3,420 | ) | (86 | ) | 5,742 |   |
| Sales and  marketing        |       | 2,543                                                    |         | 2,468 |   | 10 |   | — |   | 5,021 |   |
| Research and  development   |       | 1,597                                                    |         | 1,083 |   | 27 |   | — |   | 2,707 |   |
| General and  administrative |       | 1,294                                                    |         | 878 |   | 22 |   | — |   | 2,194 |   |
| Other                       |       | —                                                   |         | — |   | — |   | 1,222 |   | 1,222 |   |
| Total  operating expenses   |       | 5,434                                                    |         | 4,429 |   | 59 |   | 1,222 |   | 11,144 |   |
| Loss from  operations       |       | $                                                        | (41          | ) | $ | (574 | ) | $ | (3,479 | ) | $ | (1,308 | ) | $ | (5,402 | ) |

 

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| ** **                    | ** ** | **Three Months Ended January 31,  2003** | ** ** |
|-------------------------------|------------|-----------------------------------------------|------------|
| ** **                    | ** ** | **Americas**                                  | ** ** | **International** | ** ** | **SCOsource** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                          |       |                                          |       |   |   |   |   |   |   |   |   |
| Revenue                       |       | $                                             | 7,264      |   | $ | 6,190 |   | $ | — |   | $ | 86 |   | $ | 13,540 |   |
| Cost of revenue               |       | 1,359                                         |       | 1,405 |   | — |   | 114 |   | 2,878 |   |
| Gross margin                  |       | 5,905                                         |       | 4,785 |   | — |   | (28 | ) | 10,662 |   |
| Sales and marketing           |       | 2,634                                         |       | 3,801 |   | — |   | 5 |   | 6,440 |   |
| Research and development      |       | 1,422                                         |       | 1,212 |   | — |   | 16 |   | 2,650 |   |
| General and administrative    |       | 885                                           |       | 755 |   | — |   | 10 |   | 1,650 |   |
| Other                         |       | —                                        |       | — |   | — |   | 660 |   | 660 |   |
| Total operating expenses      |       | 4,941                                         |       | 5,768 |   | — |   | 691 |   | 11,400 |   |
| Income (loss) from operations |       | $                                             | 964        |   | $ | (983 | ) | $ | — |   | $ | (719 | ) | $ | (738 | ) |

 

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

 
| ** **              | ** ** | **January 31,  2004** | ** ** | **October 31,  2003** | ** ** |
|-------------------------|------------|----------------------------|------------|----------------------------|------------|
| Long-lived assets:      |       |                       |       |                       |       |
| United States           |       | $                          | 10,280     |                       | $          | 11,234 |   |
| International           |       | 352                        |       | 366                        |       |
| Total long-lived assets |       | $                          | 10,632     |                       | $          | 11,600 |   |

 

**(12) SUBSEQUENT EVENTS**

 

**End User Lawsuits**

 

On or around March 2, 2004, the Company broughtsuit against AutoZone, Inc. (“AutoZone”) for its alleged violations of theCompany’s UNIX copyrights through its use of Linux.  Specifically, the lawsuit alleges thatAutoZone violated the Company’s UNIX copyrights by running versions of theLinux operating system that contain code, structure, sequence and/ororganization from the Company’s proprietary UNIX System V code in violation ofits copyrights.  The lawsuit filed inU.S. District Court in Nevada requests injunctive relief against AutoZone’sfurther use or copying of any part of the Company’s copyrighted materials andalso requests damages as a result of AutoZone’s infringement in an amount to beproven at trial.

 

On or around March 3, 2004, the Company broughtsuit against DaimlerChrysler Corporation (“DaimlerChrysler”) for its allegedviolations of its UNIX software agreement with the Company.  Specifically, the lawsuit alleges thatDaimlerChrysler breached its UNIX software agreement with the Company byfailing to certify by January 31, 2004 its compliance with the UNIXsoftware agreement as required by the Company. The lawsuit, filed in Oakland County Circuit Court in the State ofMichigan, requests the court to issue orders declaring that DaimlerChrysler hasviolated the certification requirements of its UNIX software agreement,permanently enjoin DaimlerChrysler from further violations of the UNIX softwareagreement, issue a mandatory

 

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injunction requiringDaimlerChrysler to remedy the effects of its past violations of the UNIXsoftware agreement and award the Company damages in amount to be determined attrial together with costs, attorneys’ fees and any such other or different reliefthat the Court may deem to be equitable and just.

 

**Exchange Agreement with Series A Investors**

 

On February 5, 2004, the Company completed anexchange transaction in which each outstanding share of redeemable Series AConvertible Preferred Stock was exchanged for one share of the Company’s newredeemable Series A-1 Convertible Preferred Stock.  The exchange transaction eliminated thederivative related to the redeemable Series A Convertible Preferred Stockthat has been recorded as a current liability on the Company’s balance sheetand, after February 5, 2004, eliminates the charge in the Company’squarterly statements of operations for the change in the fair value of thederivative related to the redeemable Series A Convertible PreferredStock.  The derivative was eliminated dueto certain rights and privileges included in the new redeemable Series A-1Convertible Preferred Stock such as voting rights and rights to boardrepresentation, among others, that were not included in the redeemable Series AConvertible Preferred Stock.

 

The Company anticipates recording other income in thesecond quarter of fiscal year 2004 related to the change in the fair value ofthe Series A derivative between January 31, 2004 and February 5,2004, the date on which the exchange agreement was executed.  The Company also anticipates recording adividend in the second quarter of fiscal year 2004, related to the differencebetween the fair value of the new redeemable Series A-1 ConvertiblePreferred Stock and the carrying value of the previously issued redeemable Series AConvertible Preferred Stock and related derivative.  This dividend will reduce earnings availableto common stockholders.

 

**Stock Repurchase Program**

 

On March 10,2004, the Company’s board of directors authorized management, in itsdiscretion, to purchase up to 1,500,000 shares of the Company’s common stockover the 24-month period following March 10, 2004, the time at which therepurchase program was effective.  On March 10,2004, the Company had approximately 14,415,000 shares of common stock issuedand outstanding. Any repurchased shares will be held as treasury stock and willbe available for general corporate purposes.  

 

Therepurchase program will allow the Company to repurchase its shares from time totime in accordance with the requirements of the Securities and ExchangeCommission on the open market, in block trades and in privately negotiatedtransactions, depending on market conditions and other factors. 

 

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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-lookingstatements that involve risks and uncertainties.  Forward-looking statements can also beidentified by words such as “intends,” “anticipates,” “expects,” “believes,” “plans,”“predicts,” and similar terms. Forward-looking statements are not guarantees of future performance andour actual results may differ significantly from the results discussed in theforward-looking statements.  Factors thatmight cause such differences include, but are not limited to, those set forthbelow under “Forward-Looking Statements” and “Risk Factors” and elsewhere inthis Amendment No. 1 to Form 10-Q/A. The following discussion shouldbe read in conjunction with our consolidated financial statements and notesthereto included in this Amendment No. 1 to Form 10-Q/A and ourannual report on Form 10-K for the year ended October 31, 2003 filedwith the Securities and Exchange Commission, including the audited financialstatements and management’s discussion and analysis contained therein.  All information presented herein is based onour quarter ended January 31, 2004. We assume no obligation to revise or update any forward-lookingstatements for any reason, except as required by law.*

 

**Restatement ofFinancial Statements**

 

As discussed in Note 2 to the Financial Statements,the Company’s condensed, consolidated financial statements for the three monthsended January 31, 2004 have been restated. The accompanying management’s discussion and analysis gives effect tothat restatement.

 

**Overview**

 

*Historical Background. *We originally incorporatedas Caldera Systems, Inc., a Utah corporation (“Caldera Systems”), on August 21,1998, and reincorporated as a Delaware corporation on March 6, 2000.  In March 2000, we completed an initialpublic offering of our common stock.  On May 7, 2001, we formed a new holdingcompany in Delaware under the name of Caldera International, Inc. toacquire substantially all of the assets and operations of the server andprofessional services groups of The Santa Cruz Operation (now known asTarantella, Inc.).  In connectionwith this acquisition, Caldera Systems became a wholly-owned subsidiary ofCaldera International, Inc.  Formerholders of shares and options to purchase shares of Caldera Systems received anequal number of shares and options to purchase shares in Caldera International, Inc.  On May 16,2003, our stockholders approved our corporate name change to The SCO Group, Inc.

 

*RecentDevelopments.*On October 16, 2003, we completed a$50,000,000 private placement of 50,000 shares of our redeemable Series AConvertible Preferred Stock and received net proceeds of approximately$47,740,000.  On February 5, 2004,we completed an exchange transaction in which each outstanding share ofredeemable Series A Convertible Preferred Stock was exchanged for oneshare of our new redeemable Series A-1 Convertible Preferred Stock.  The exchange transaction eliminated thederivative related to the redeemable Series A Convertible Preferred Stockthat was recorded as a current liability on our balance sheet and, after February 5,2004, eliminates the charge in our quarterly statements of operations for thechange in the fair value of the derivative related to the redeemable Series AConvertible Preferred Stock.  Thederivative was eliminated due to certain rights and privileges included in thenew redeemable Series A-1 Convertible Preferred Stock such as votingrights and rights to board representation, among others, that were not includedin the redeemable Series A Convertible Preferred Stock.

 

We anticipate recordingother income in the second quarter of fiscal year 2004 related to the change inthe fair value of the derivative between January 31, 2004 and February 5,2004, the

 

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effective date of our exchange transaction.  We also anticipate recording a dividend inthe second quarter of fiscal year 2004, related to the difference between thefair value of the new redeemable Series A-1 Convertible Preferred Stockand the carrying value of the previously issued redeemable Series AConvertible Preferred Stock and related derivative.  This dividend will reduce earnings to commonstockholders.

 

On or about January 20, 2004,we brought suit against Novell, Inc. for slander of title seeking relieffor Novell’s alleged bad faith efforts to interfere with our copyrights relatedto its UNIX source code and derivative works and our UnixWare product.  In the lawsuit, we request preliminary andpermanent injunctive relief as well as damages. The injunction would requireNovell to assign to us all copyrights that we believe Novell has wrongfullyregistered, prevent Novell from representing any ownership interest in thosecopyrights and require Novell to retract or withdraw all representations it hasmade regarding its purported ownership of those copyrights.  The case is currently pending in the ThirdJudicial District Court in Salt Lake County, Utah.  Novell has not yet answered our complaint buthas filed with the United States District Court for the District of Utah anotice removing the case to such federal court and a motion with the ThirdJudicial District Court in Salt Lake County, Utah to transfer the venue of thecase from such court to the Fourth Judicial District Court in Utah County,Utah. Neither court has ruled on these actions. Novell also filed a motion todismiss our complaint claiming it never transferred the copyrights to The SantaCruz Operation.  We have filed a responseto Novell’s motion to dismiss and have also filed a motion to remand the caseback to the state court.  The court hasnot ruled on these motions.  We plan tovigorously pursue our claims against Novell.

 

On or about March 2,2004, we brought suit against AutoZone, Inc. for its alleged violations ofour UNIX copyrights through its use of Linux. Specifically, the lawsuit alleges that AutoZone violated our UNIXcopyrights by running versions of the Linux operating system that contain code,structure, sequence and/or organization from our proprietary UNIX System V codein violation of our copyrights.  Thelawsuit filed in U.S. District Court in Nevada requests injunctive reliefagainst AutoZone’s further use or copying of any part of our copyrightedmaterials and also requests damages as a result of AutoZone’s infringement inan amount to be proven at trial.

 

On or about March 3, 2004, we brought suitagainst DaimlerChrysler Corporation for its alleged violations of its UNIXsoftware agreement with us. Specifically, the lawsuit alleges that DaimlerChrysler breached its UNIXsoftware agreement with us by failing to voluntarily certify by January 31,2004 its compliance with the UNIX software agreement as required by us.  The lawsuit, filed in Oakland County CircuitCourt in the State of Michigan, requests the court to issue orders declaringthat DaimlerChrysler has violated the certification requirements of its UNIXsoftware agreement, permanently enjoin DaimlerChrysler from further violationsof the UNIX software agreement, issue a mandatory injunction requiringDaimlerChrysler to remedy the effects of its past violations of the UNIXsoftware agreement and award us damages in amount to be determined at trialtogether with costs, attorneys’ fees and any such other or different reliefthat the Court may deem to be equitable and just.

 

On March 10, 2004, our board of directorsauthorized management, in its discretion, to purchase up to 1,500,000 shares ofour common stock over a 24-month period. Shares may be purchased in open market transactions, block purchases orprivately negotiated transactions.  Anyrepurchased shares will be held as treasury stock and will be available forgeneral corporate purposes.  

 

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**Business Focus**

 

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 and independentsolution providers.  We have localoffices in a number of countries that provide support and services to customersand resellers in that geographic area. The other principal channel for selling and marketing our UNIX productsis through major corporations that have a large number of replicated sites orfranchisees.  We access thesecorporations through their information technology or purchasing departmentswith our Area Sales Managers in the United States and through our resellerchannel in countries outside the United States. In addition, we also sell our operating system products to OEMs. Until fiscal year 2003, the majority of our revenue and our operating expenseswere derived from our UNIX business.

 

The revenue derived from our UNIX business was $11,372,000 and$13,540,000 for the three months ended January 31 2004 and 2003,respectively.  The revenue from thisbusiness has been declining in each of the last four years primarily as aresult of increased competition from alternative operating systems,particularly Linux, lower information technology spending and the generaleconomic slowdown.  If we areunable to generate positive cash flow and profitable operations, our UNIXoperations may be adversely impacted.

 

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 system products.  This wouldlead to an accelerated decline in our UNIX products and services revenue.

 

In an effort to offset thisdecrease in UNIX revenue, we have decreased our operating costs and increasedour gross margin percentage over the last three fiscal years.  Operating costs decreased from $11,400,000for the three months ended January 31, 2003 to $11,144,000 (restated) forthe three months ended January 31, 2004. We have reduced the number of employees from 339 as of January 31,2003 to 303 as of January 31, 2004, eliminated redundant facilities andreduced other discretionary spending while still preserving our worldwideinfrastructure.  Our gross marginpercentage from our UNIX business increased from 79 percent for the threemonths ended January 31, 2003, to 81 percent for the three months ended January 31,2004.  We have accomplished this byreducing excess manufacturing and overhead costs, reducing our third-partyroyalty and technology costs and decreasing the number of employees in ourservices organization.  

 

An important initiative forour UNIX business for our 2004 fiscal year will be continuing to maintain thelevel of investment in and commitment to our UNIX operating systems.  As part of this initiative, we intend tocontinue to invest in research and development efforts for our UNIX divisionfor fiscal year 2004 to provide our OpenServer and UnixWare products withincreased system reliability, maintain backward compatibility with existingapplications and software, provide increased application support, provideadditional hardware support, integrate widely used internet applications andincrease system performance.  Theseenhancements will

 

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nothave a direct impact on our short-term UNIX revenue because of the longadoption cycle for new operating system purchases and our long operating systemproduct sales cycle.

 

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

 

To offset the decline in ourUNIX business and review the status of our UNIX licensing and sublicensingagreements, we initiated our SCOsource licensing initiatives in January 2003.  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.  Infiscal year 2004, we plan to increase our SCOsource sales team as we continueto implement our SCOsource licensing strategies.

 

Our future success with ourSCOsource initiatives and future revenue from SCOsource licenses will depend onour ability to protect our UNIX intellectual property.  We will continue to devote resources to ourSCOsource initiatives, and we generally expect quarterly legal fees and otherSCOsource related costs for the remaining quarters of fiscal year 2004 will beconsistent with the level of costs incurred in the first quarter of fiscal year2004.  However, legal expensescould increase over time depending on developments in the litigation involvingus, and certain events may take place that could require us to pay a 20 percentcontingency fee to our law firms.  Theseevents may include settlements, judgments, licensing fees, subject to certainexceptions, and a sale of our company during the pendancy of litigation orthrough settlement, subject to agreed upon credits for amounts received asdiscounted hourly fees and unused retainer fees.  Additionally, our agreement with our lawfirms may also be construed to include contingency fee payments in connectionwith any issuance of our equity securities.

 

Because of the uncertainties related to our SCOsourcebusiness, we are unable to estimate the amount and timing of future SCOsourcelicensing revenue.  This uncertaintyrepresents a significant risk and challenge for us, both in the short and longterm.  If we do receive revenue from thissource, it may be sporadic and fluctuate from quarter to quarter.  Our SCOsource initiatives are unlikely toproduce a stable or predictable revenue stream for the foreseeable future.  Additionally, the success of theseinitiatives may depend on the strength of our intellectual property rights andcontractual claims regarding UNIX, including the strength of our claim thatunauthorized UNIX source code and derivative works are prevalent in Linux.  We generated minimal SCOsource revenue in thefirst quarter of fiscal year 2004, but anticipate that revenue from vendorlicenses and IP licenses will increase throughout the remainder of fiscal year2004.

 

**CriticalAccounting Policies**

 

Our critical accountingpolicies and estimates include the following:

 

•                                          Revenue recognition;

 

•                                          Deferred income taxes and related valuationallowances;

 

•                                          Fair value of derivative financial instrument;

 

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•                                          Impairment of long-lived assets; and

 

•                                          Allowances for doubtful accounts.

 

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

 

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

 

Estimates used in our revenue recognition include thedetermination of credit-worthiness and verification of sales-out reporting toend users through our two-tier distribution channel.  To the extent these estimates were incorrectour recognized revenue would be adversely impacted and would harm our resultsof operations.  Additionally, if ourbusiness conditions change or our revenue contracts begin to contain moremultiple elements, our future revenue recognition in future periods may beimpacted as a larger component of revenue may be deferred.  As of January 31, 2004, our deferredrevenue balance was $6,952,000 and related primarily to product maintenance andsupport contracts.

 

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

 

*Fair Value of Derivative FinancialInstrument*.  On October 16,2003, we issued 50,000 shares of our redeemable Series A ConvertiblePreferred Stock for $1,000 per share. The net proceeds from the sale of the preferred stock were$47,740,000.  The terms of the preferredstock include conversion and a number of redemption provisions that represent aderivative financial instrument under SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities,” as amended.  We determined that the conversion featureallowing the holders of the preferred stock to acquire common shares is anembedded derivative financial instrument that does not qualify as a scopeexemption under the provisions of Emerging Issues Task Force (“EITF”) 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in aCompany’s Own Stock.”  

 

As of October 16, 2003, through the assistance ofan independent valuation firm, we determined the initial fair value of thederivative was $18,069,000 and the value of the preferred stock was$29,671,000.  We were required to accountfor the conversion feature as an embedded derivative since the preferred stock instrumentdid not entitle the holders to equity features such as voting rights and boardrepresentation.  As of October 31,2003, the fair value of the derivative

 

29

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was $15,224,000 and thedecrease in fair value of $2,845,000 was recorded as other income in thestatement of operations for fiscal year 2003. As of January 31, 2004, the fair value of the derivative was$11,600,000 and the decrease in fair value of $3,624,000 was recorded as otherincome in our condensed consolidated statement of operations for the threemonths ended January 31, 2004. Significant estimates used by management in the valuation of thederivative as of January 31, 2004 included an expected term of threeyears, a yield rate for the security of 15 percent and the value of our commonstock of $14.37.  

 

On February 5, 2004, we completed an exchangetransaction in which each outstanding share of redeemable Series AConvertible Preferred Stock was exchanged for one share of our new redeemable Series A-1Convertible Preferred Stock. The exchange transaction eliminated the derivativerelated to the redeemable Series A Convertible Preferred Stock that wasinitially recorded as a current liability on our balance sheet and eliminatesthe charge in our quarterly statements of operations for the change in the fairvalue of the derivative related to the redeemable Series A ConvertiblePreferred Stock.  The derivative waseliminated due to certain rights and privileges included in the new redeemable Series A-1Convertible Preferred Stock such as voting rights and rights to boardrepresentation, among others, that were not included in the redeemable Series AConvertible Preferred Stock.  

 

We anticipate recording other income in the secondquarter of fiscal year 2004, related to the change in the fair value of thederivative between January 31, 2004 and February 5, 2004, the time atwhich the exchange agreement was executed. We also anticipate recording a dividend in the second quarter of fiscalyear 2004, related to the difference between the fair value of the newredeemable Series A-1 Convertible Preferred Stock and the carrying valueof the previously issued redeemable Series A Convertible Preferred Stockand related derivative.  This dividend willreduce earnings to common stockholders.

 

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

 

We performed an impairment analysis as of January 31,2004 in accordance with SFAS No. 142, “Goodwill and Other IntangibleAssets,” and determined that the goodwill reported in the consolidated balancesheets is not impaired.  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.  Ifwe are not able to generate revenue in future quarters from our web servicestechnology acquired from Vultus, Inc. in fiscal year 2003, we may berequired to record an impairment charge in a future period related to thecarrying value of our goodwill and intangible assets with finite lives.

 

*Allowance for Doubtful Accounts*.  Weoffer credit terms on the sale of our products to a majority of our customersand require no collateral from these customers. We perform ongoing credit evaluations of our customers’ financialcondition and maintain an allowance for doubtful accounts based upon ourhistorical collection experience and expected collectibility of all accountsreceivable and have applied these policies consistently throughout the threemonths ended January 31, 2004.  Ourallowance for doubtful accounts based on our historical experience and specificreview as of January 31, 2004, was approximately $231,000.  Our past experience has

 

30

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resultedin minimal differences from the actual amounts provided for bad debts and ourrecorded estimates.  However, our actualbad debts in future periods may differ from our current estimates and thedifferences may be material, which may have an adverse impact on ourfuture accounts receivable and cash position.

 

**Results of Operations**

 

Thefollowing table presents our results of operations for the three months ended January 31,2004 and 2003:

 
| ** **                                                         | ** ** | **Three Months Ended January 31,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------|------------|
| **Statement of Operations Data:**                                  | ** ** | **2004**                                | ** ** | **2003** | ** ** |
| ** **                                                         | ** ** | **(restated)**                          | ** ** | ** ** | ** ** |
| Revenue:                                                           |       |                                    |       |   |   |
| Products                                                           |       | $                                       | 9,712      |   | $ | 11,090 |   |
| SCOsource  licensing                                               |       | 20                                      |       | — |   |
| Services                                                           |       | 1,660                                   |       | 2,450 |   |
| Total revenue                                                      |       | 11,392                                  |       | 13,540 |   |
| Cost of revenue:                                                   |       |                                    |       |   |   |
| Products                                                           |       | 888                                     |       | 1,186 |   |
| SCOsource  licensing                                               |       | 3,440                                   |       | — |   |
| Services                                                           |       | 1,322                                   |       | 1,692 |   |
| Total cost of  revenue                                             |       | 5,650                                   |       | 2,878 |   |
| Gross margin                                                       |       | 5,742                                   |       | 10,662 |   |
| Operating  expenses:                                               |       |                                    |       |   |   |
| Sales and  marketing                                               |       | 5,021                                   |       | 6,440 |   |
| Research and  development                                          |       | 2,707                                   |       | 2,650 |   |
| General and  administrative                                        |       | 2,194                                   |       | 1,650 |   |
| Restructuring  charges (reversals)                                 |       | —                                  |       | (252 | ) |
| Amortization of  intangibles                                       |       | 787                                     |       | 700 |   |
| Stock-based  compensation                                          |       | 435                                     |       | 212 |   |
| Total operating  expenses                                          |       | 11,144                                  |       | 11,400 |   |
| Loss from  operations                                              |       | (5,402                                  | )          | (738 | ) |
| Equity in income  (losses) of affiliates                           |       | 37                                      |       | (25 | ) |
| Other income,  net                                                 |       | 3,763                                   |       | 44 |   |
| Provision for  income taxes                                        |       | (128                                    | )          | (5 | ) |
| Net loss                                                           |       | (1,730                                  | )          | (724 | ) |
| Dividends on  Series A Redeemable Convertible Preferred Stock |       | (756                                    | )          | — |   |
| Net loss  applicable to common stockholders                        |       | $                                       | (2,486     | ) | $ | (724 | ) |

 

**THREE MONTHS ENDED JANUARY 31, 2004 AND 2003**

 

### ***Revenue***

 
| ** ** | ** ** | **Three Months Ended January 31,** | ** ** |
|------------|------------|-----------------------------------------|------------|
| ** ** | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|       |       |                                    |       |   |   |   |   |
| Revenue    |       | $                                       | 11,392,000 |   | (16 | )% | $ | 13,540,000 |   |
|            |            |                                         |            |  |  |  |  |  |  |

 

Revenue for the first quarter of fiscal year 2004decreased by $2,148,000, or 16 percent, from the first quarter of fiscal year2003, and this decrease was primarily attributable to decreased UNIX productsand services revenue. 

 

Revenue generated from our UNIX operating divisions(Americas and International) and SCOsource division was as follows:

 

31

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| ** **                | ** ** | **Three Months Ended January 31,** | ** ** |
|---------------------------|------------|-----------------------------------------|------------|
| ** **                | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                      |       |                                    |       |   |   |   |   |
| Americas revenue          |       | $                                       | 6,763,000  |   | (7 | )% | $ | 7,264,000 |   |
| Percent of total  revenue |       | 59                                      | %          |   |   | 54 | % |
| International  revenue    |       | 4,673,000                               |       | (25% | )% | 6,190,000 |   |
| Percent of total  revenue |       | 41                                      | %          |   |   | 45 | % |
| SCOsource  revenue        |       | 20,000                                  |       | n/a |   | — |   |
| Percent of total  revenue |       | 1                                       | %          |   |   | — |   |
| Other revenue             |       | (64,000                                 | )          | n/a |   | 86,000 |   |
| Percent of total  revenue |       | (1                                      | )%         |   |   | 1 | % |
|                           |            |                                         |            |  |  |  |  |  |  |

 

Thedecrease in revenue from our International division for the first quarter offiscal year 2004 compared to the first quarter of fiscal year 2003 wasprimarily related to the negative impact of the slowing 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 in the Americas and the International divisions will be consistentwith or slightly lower than revenue generated in the first quarter of fiscalyear 2004 and that the percentage split between these two UNIX divisions willbe generally consistent with that in the first quarter of fiscal year2004.  Our UNIX product and servicesrevenue may be lower than currently anticipated if we lose the support of anyof our existing hardware and software vendors or our key industry partnerswithdraw their marketing and certification support or direct their support toour competitors.  This may occur as aresult of our SCOsource initiatives and in particular as a result of anylawsuits we have brought and may bring against end users violating ourintellectual property and contractual rights.

 

*Products Revenue*

 
| ** **                | ** ** | **Three Months Ended January 31,** | ** ** |
|---------------------------|------------|-----------------------------------------|------------|
| ** **                | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                      |       |                                    |       |   |   |   |   |
| Products revenue          |       | $                                       | 9,712,000  |   | (12 | )% | $ | 11,090,000 |   |
| Percent of total  revenue |       | 85                                      | %          |   |   | 82 | % |
|                           |            |                                         |            |  |  |  |  |  |  |

 

Our products revenue consists of software licensesfor UNIX products such as OpenServer and UnixWare, as well as sales ofUNIX-related products.  Products revenuealso includes revenue derived from OEMs.  We rely heavily on our two-tierdistribution channel for approximately 50 percent of our products revenue inthe Americas and approximately 90 percent of our revenue in our Internationaldivision, and any disruption in our distribution channel could have an adverseimpact on future revenue.  

 

The decrease in products revenue in the first quarterof fiscal year 2004 as compared with the first quarter of fiscal year 2003 wasprimarily attributable to decreased sales of UnixWare and other productsprimarily resulting from increased competition in the operating system market,particularly Linux, and from a decrease in information technology spending andthe worldwide economic slowdown.  Thisimpact was felt in all of our distribution channels, and we believe that thiscompetition from Linux will continue in future periods.  

 

32

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

 
| ** **                   | ** ** | **Three Months Ended January 31,** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|
| ** **                   | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                         |       |                                    |       |   |   |   |   |
| OpenServer  revenue          |       | $                                       | 5,202,000  |   | 10 | % | $ | 4,741,000 |   |
| Percent of  products revenue |       | 54                                      | %          |   |   | 43 | % |
| UnixWare revenue             |       | 2,738,000                               |       | (34 | )% | 4,164,000 |   |
| Percent of  products revenue |       | 28                                      | %          |   |   | 38 | % |
| Other products  revenue      |       | 1,772,000                               |       | (19 | )% | 2,185,000 |   |
| Percent of  products revenue |       | 18                                      | %          |   |   | 20 | % |
|                              |            |                                         |            |  |  |  |  |  |  |

 

*SCOsource Licensing Revenue*

 
| ** **                   | ** ** | **Three Months Ended January 31,** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|
| ** **                   | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                         |       |                                    |       |   |   |   |   |
| SCOsource  licensing revenue |       | $                                       | 20,000     |   | n/a |   | $ | — |   |
| Percent of total  revenue    |       | 0                                       | %          |   |   | — |   |
|                              |            |                                         |            |  |  |  |  |  |  |

 

SCOsource licensing revenue was $20,000 for firstquarter of fiscal year 2004 as compared to no revenue from this source for thefirst quarter of fiscal year 2003.  Thisrevenue is the result of our SCOsource initiatives launched beginning in January 2003,including our recently announced worldwide SCOsource IP licensing program.  We initiated our SCOsource initiatives toprotect our intellectual property rights in our UNIX source code.  We anticipate increased revenue during futurequarters of fiscal year 2004 from our SCOsource activities in the form ofvendor licenses and IP licenses. However, we are unable to predict the amount and timing of revenue fromour SCOsource initiatives for future periods because of the uncertaintiesrelated to SCOsource licensing revenue.

 

*Services Revenue*

 
| ** **                | ** ** | **Three Months Ended January 31,** | ** ** |
|---------------------------|------------|-----------------------------------------|------------|
| ** **                | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                      |       |                                    |       |   |   |   |   |
| Services revenue          |       | $                                       | 1,660,000  |   | (32 | )% | $ | 2,450,000 |   |
| Percent of total  revenue |       | 15                                      | %          |   |   | 18 | % |
|                           |            |                                         |            |  |  |  |  |  |  |

 

Services revenue consists primarily of annual andincident support fees, engineering services fees, professional services andeducation fees.  These fees are typicallycharged and invoiced separately from UNIX products sales.  The $790,000 decrease in services revenue inthe first quarter of fiscal year 2004 as compared to the first quarter offiscal year 2003 was in part due to a decrease in professional servicesresulting 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. 

 

The majority of our support and professional servicesrevenue continues to be derived from services for UNIX-based operating systemproducts.  Our future level of servicesrevenue depends in part on our ability to generate UNIX products revenue fromnew customers as well as the renewal of certain annual support and servicesagreements with existing UNIX customers.

 

33

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*Cost of Products Revenue*

 
| ** **                      | ** ** | **Three Months Ended January 31,** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|
| ** **                      | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                            |       |                                    |       |   |   |   |   |
| Cost of products  revenue       |       | $                                       | 888,000    |   | (25 | )% | $ | 1,186,000 |   |
| Percentage of  products revenue |       | 9                                       | %          | 11 | % |   |   |
|                                 |            |                                         |            |  |  |  |  |  |  |

 

Cost of products revenue includes primarily overheadcosts, manufacturing costs, royalties to third-party vendors and technologycosts.  Cost of products revenuedecreased by $298,000 in the first quarter of fiscal year 2004 compared to thefirst quarter of fiscal year 2003.  Thisdecrease was primarily attributable to reduced overhead and manufacturing costsresulting from our cost reduction efforts, decreased royalties to third partyvendors and lower amortized technology costs. 

 

For the remaining quarters of fiscal year 2004, weexpect the dollar amount of our cost of products revenue to be consistent toour cost of products revenue incurred in the first quarter of fiscal year 2004.

 

*Cost of SCOsource Licensing Revenue*

 
| ** **                                 | ** ** | **Three Months Ended January 31,** | ** ** |
|--------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                 | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                                       |       |                                    |       |   |   |   |   |
| Cost of  SCOsource licensing revenue       |       | $                                       | 3,440,000  |   | n/a |   | $ | — |   |
| Percentage of  SCOsource licensing revenue |       | 17200                                   | %          |   |   | — |   |
|                                            |            |                                         |            |  |  |  |  |  |  |

 

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

 

For the second quarter of fiscal year 2004, we expectour cost of SCOsource licensing revenue to be generally consistent with ourcost of SCOsource license revenue generated in the first quarter of fiscal year2004.  However, cost of SCOsource licensingrevenue likely will fluctuate from quarter to quarter due in part to theunpredictability of the related SCOsource revenue and the level of legal andprofessional expenses incurred in connection with our efforts to protect ourintellectual property rights.  Legalexpenses could increase over time depending on developments in the litigationinvolving us.  Legal expenses may alsoinclude contingency payments made to the law firms engaged by us to protect ourintellectual property rights. Additionally, we are unable to predict the percentage of cost ofSCOsource licensing revenue for future quarters due to the unpredictability ofthe related licensing revenue.

 

*Cost of Services Revenue*

 
| ** **                      | ** ** | **Three Months Ended January 31,** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|
| ** **                      | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                            |       |                                    |       |   |   |   |   |
| Cost of services  revenue       |       | $                                       | 1,322,000  |   | (22 | )% | $ | 1,692,000 |   |
| Percentage of  services revenue |       | 80                                      | %          |   |   | 69 | % |
|                                 |            |                                         |            |  |  |  |  |  |  |

 

Cost of services revenue includes the salaries andrelated personnel costs of employees delivering services revenue as well asthird-party service agreements.  Cost ofservices revenue decreased by $370,000 for the first quarter of fiscal year2004 compared to the first quarter of fiscal year 2003.  This decrease was attributable toreduced employee and related costs in our

 

34

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support services and professional services groups as well as theelimination of certain third-party support contracts in order to increase thegross margin for these groups. 

 

For the remaining quarters of fiscal year 2004, weexpect the dollar amount of our cost of services revenue to be slightly lowerthan our cost of services revenue incurred in the first quarter of fiscal year2004.

 

*Sales and Marketing*

 
| ** **                   | ** ** | **Three Months Ended January 31,** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|
| ** **                   | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                         |       |                                    |       |   |   |   |   |
| Sales and  marketing expense |       | $                                       | 5,021,000  |   | (22 | )% | $ | 6,440,000 |   |
| Percentage of  total revenue |       | 44                                      | %          |   |   | 48 | % |
|                              |            |                                         |            |  |  |  |  |  |  |

 

Sales and marketing expenses consist of the salaries,commissions and other personnel costs of employees involved in the revenuegeneration process, as well as advertising and corporate allocations.  The decrease in sales and marketing expensesfrom the first quarter of fiscal year 2003 to the first quarter of fiscal year2004 of $1,419,000 was primarily attributable to reductions in sales andmarketing employees, reduced travel expenses, and lower commissions and lowerco-operative advertising costs as a result of lower revenue.  Our sales and marketing personnel decreasedfrom 142 as of January 31, 2003, to 100 as of January 31, 2004. 

 

For the remaining quarters of fiscal year 2004, weanticipate the dollar amount of sales and marketing expenses will decreasecompared to the first quarter of fiscal year 2004.

 

*Research and Development*

 
| ** **                        | ** ** | **Three Months Ended January 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                        | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                              |       |                                    |       |   |   |   |   |
| Research and  development expense |       | $                                       | 2,707,000  |   | 2 | % | $ | 2,650,000 |   |
| Percentage of  total revenue      |       | 24                                      | %          |   |   | 20 | % |
|                                   |            |                                         |            |  |  |  |  |  |  |

 

Research and development expenses consist of thesalaries and benefits of software engineers, consulting expenses as well ascorporate allocations.  The increase inresearch and development expense in the first quarter of fiscal year 2004 of$57,000 compared to the first quarter of fiscal year 2003 was primarilyattributable to increased development work and enhancements of our two UNIXoperating system products, OpenServer and UnixWare.  Our research and development personnelincreased from 79 as of January 31, 2003, to 86 as of January 31,2004.  

 

For the remaining quarters of fiscal year 2004, weanticipate the dollar amount of research and development expenses will remainconsistent with, or increase slightly compared to, the first quarter of fiscalyear 2004.

 

*General and Administrative*

 
| ** **                          | ** ** | **Three Months Ended January 31,** | ** ** |
|-------------------------------------|------------|-----------------------------------------|------------|
| ** **                          | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                                |       |                                    |       |   |   |   |   |
| General and  administrative expense |       | $                                       | 2,194,000  |   | 33 | % | $ | 1,650,000 |   |
| Percentage of  total revenue        |       | 19                                      | %          |   |   | 12 | % |
|                                     |            |                                         |            |  |  |  |  |  |  |

 

General and administrative expenses consist of thesalaries and benefits of finance, human resources and executive management andexpenses for professional services as well as corporate allocations.  The increase in general and administrativeexpense from the first quarter

 

35

----

 

of fiscal year 2003 compared to the firstquarter of fiscal year 2004 of $544,000 was primarily attributable to newcompliance and reporting regulations under the Sarbanes-Oxley Act of 2002 andother new regulatory requirements, increased legal costs as a result ofcorporate legal matters and other legal and professional costs not categorizedas SCOsource cost of revenue as well as from increased personnel and relatedcosts.  Our general and administrativepersonnel increased from 52 as of January 31, 2003 to 60 as of January 31,2004.  

 

For the remaining quarters of fiscal year 2004, weanticipate the dollar amount of general and administrative expenses will belower than those costs incurred in the first quarter of fiscal year 2004.

 

*Restructuring Charges (Reversals)*

 
| ** **                         | ** ** | **Three Months Ended January 31,** | ** ** |
|------------------------------------|------------|-----------------------------------------|------------|
| ** **                         | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                               |       |                                    |       |   |   |   |   |
| Restructuring  charges (reversals) |       | $                                       | —     |   |   |   | $ | (252,000 | ) |
| Percentage of  total revenue       |       | n/a                                     |       |   |   | (2 | )% |
|                                    |            |                                         |            |  |  |  |  |  |  |

 

During the first quarter of fiscal year 2003, werecorded a reversal of a previously recorded restructuring charge of$252,000.  The net restructuring chargefor the first quarter of fiscal year 2003 was comprised of adjustments topreviously recorded restructuring charges for actual payments made.

 

*Amortization of Intangibles*

 
| ** **                   | ** ** | **Three Months Ended January 31,** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|
| ** **                   | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                         |       |                                    |       |   |   |   |   |
| Amortization of  intangibles |       | $                                       | 787,000    |   | 12 | % | $ | 700,000 |   |
| Percentage of  total revenue |       | 7                                       | %          |   |   | 5 | % |
|                              |            |                                         |            |  |  |  |  |  |  |

 

The increase inamortization of intangibles of $87,000 for the first quarter of fiscal year2004 compared to the first quarter of fiscal year 2003 was primarilyattributable to amortization expense recorded on certain assets and technologyacquired from Vultus, Inc.  

 

*Stock-basedCompensation*

 
| ** **                   | ** ** | **Three Months Ended January 31,** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|
| ** **                   | ** ** | **2004**                                | ** ** | **Change** | ** ** | **2003** | ** ** |
|                         |       | **(restated)**                          |       |   |   |   |   |
| Stock-based  compensation    |       | $                                       | 435,000    |   | 105 | % | $ | 212,000 |   |
| Percentage of total  revenue |       | 4                                       | %          |   |   | 2 | % |
|                              |            |                                         |            |  |  |  |  |  |  |

 

 

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

 
| ** **                                | ** ** | **Three Months Ended January 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                | ** ** | **2004**                                | ** ** | **2003** | ** ** |
| ** **                                | ** ** | **(restated)**                          | ** ** | ** ** | ** ** |
| Amortization of  stock-based compensation |       | $                                       | 110        |   | $ | 156 |   |
| Options and  shares for services          |       | 233                                     |       | 56 |   |
| Modifications to  options                 |       | 92                                      |       | — |   |
| Total                                     |       | $                                       | 435        |   | $ | 212 |   |

 

36

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*Equity in Income (Losses) of Affiliates*

 

Weaccount for our ownership interests in companies that we own at least 20percent and less than 50 percent using the equity method of accounting.  Under the equity method, we record ourportion of the entities’ net income or net loss in our condensed consolidatedstatements of operations.  During thefirst quarter of fiscal year 2004 we recorded income of $37,000 primarilyrelated to income from our joint venture in China compared to a loss of $25,000in the first quarter of fiscal year 2003 primarily related to our investment inVista, Inc.  

 

*OtherIncome (Expense), net*

 

Otherincome (expense) consisted of the following components for the three monthsended January 31, 2004 and 2003 (in thousands):

 
| ** **                          | ** ** | **Three Months Ended January 31,** | ** ** |
|-------------------------------------|------------|-----------------------------------------|------------|
| ** **                          | ** ** | **2004**                                | ** ** | **2003** | ** ** |
|                                |       |                                    |       |   |   |
| Interest income                     |       | $                                       | 270        |   | $ | 39 |   |
| Change in fair  value of derivative |       | 3,624                                   |       | — |   |
| Other income  (expense), net        |       | (131                                    | )          | 5 |   |
| Total other  income, net            |       | $                                       | 3,763      |   | $ | 44 |   |

 

Interestincome increased by $231,000 for the first quarter of fiscal year 2004 comparedto the first quarter of fiscal year 2003 as a result of interest earned onhigher cash balances.  The incomerecorded on the change in fair value of the derivative was a result of thedifference in the fair value between January 31, 2004 and October 31,2003.  We anticipate recording otherincome in the second quarter of fiscal year 2004 related to the change in thefair value of the derivative between January 31, 2004 and February 5,2004, the time at which the exchange agreement was executed.

 

*Provision for Income Taxes*

 

The provision for income taxes was $128,000 in thefirst quarter of fiscal year 2004 and $5,000 in the first quarter of fiscalyear 2003.  The increase in the provision for income taxes of $123,000 for thefirst quarter of fiscal year 2004 compared to the first quarter of fiscal year2003 was attributable to earnings of our foreign subsidiaries.

 

*DividendsRelated to Convertible Preferred Stock*

 

### **On February 5, 2004, weissued 50,000 shares of our redeemable Series A-1 Convertible PreferredStock in exchange for all previously outstanding shares of redeemable Series AConvertible Preferred Stock.  Dividendswill accrue from October 16, 2004, the first anniversary of the original October 16,2003 closing of the redeemable Series A Convertible Preferred Stock privateplacement, and will be paid quarterly beginning in the 30-day period following January 31,2005 at a rate of 8 percent per annum, subject to annual increases of 2 percentper annum, not to exceed 12 percent per annum. Because dividends are not payable until after January 31, 2005, wehave accrued dividends of $756,000 for the first quarter of fiscal year 2004,which reduced earnings available to common stockholders.  We had no dividends accrued or payable in thefirst quarter of fiscal year 2003.**

### ** **

**Liquidityand Capital Resources**

 

Our cash and equivalents balance decreased from$64,428,000 as of October 31, 2003 to $46,991,000 as of January 31,2004 and working capital decreased from $37,168,000 as of October 31, 2003to $36,451,000 as of January 31, 2004. During fiscal year 2003, we generated positive cash flow from operationsfor the first time in our operating history. This was achieved through reductions in costs and increased gross margingenerated from our UNIX business and significant

 

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license revenue generated from our SCOsource business.  We also completed the placement of 50,000shares of our redeemable Series A Convertible Preferred Stock for netproceeds of $47,740,000 in October 2003, which shares were exchanged forshares of redeemable Series A-1 Convertible Preferred Stock in February 2004.  We intend to use the proceeds from ourpreferred stock financing as well as our other cash resources to maintain andenhance our UNIX business and pursue our SCOsource initiatives.  We believe that we will have sufficient cashresources to fund our current operations for at least the next 12 months.

 

Ournet cash used in operations during the first quarter of fiscal year 2004 was$4,319,000.  Cash used in operations wasattributable to a net loss of $1,730,000 (restated), non-cash expenses of$2,103,000 and from changes in operating assets and liabilities of$486,000.  Our current liabilitiesdecreased from $45,112,000 to $39,821,000 (restated) during the first quarterof fiscal year 2004 primarily related to the decrease in the fair-value of thederivative related to the redeemable Series A Convertible Preferred Stockand the decrease in accrued compensation to law firms. 

 

Ourinvesting activities have historically consisted of equipment purchases,investing in strategic partners and the purchase and sale of available-for-salesecurities.  During the first quarter offiscal year 2004, cash used in investing activities was $13,752,000, which wasprimarily a result of our purchase of available-for-sale securities of$14,989,000 and equipment purchases of $131,000, offset by proceeds receivedfrom the sale of available-for-sale securities of $1,368,000.  

 

Ourfinancing activities provided $667,000 during the first quarter of fiscal year2004 and consisted primarily of proceeds received from the exercise of stockoptions of $297,000 and proceeds from the purchase of shares of common stock byour employees through our employee stock purchase program of $370,000.  

 

The certificate of designation creating our redeemableSeries A-1 Convertible Preferred Stock includes redemption provisions thatif triggered would require us to repurchase for cash the outstanding shares ofour redeemable Series A-1 Convertible Preferred Stock.  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 the appointmentof a trustee or receiver for it or a substantial part of its business, thebankruptcy, reorganization, liquidation or similar proceedings instituted by oragainst our company or any of its subsidiaries, a change in control eventoccurring with respect to our company or our failure to pay when due anyindebtedness in excess of $1,000,000 or otherwise our default under anyagreement binding our company that would likely result in a material adverseeffect on our business.  If we wererequired to pay cash to the holders of our redeemable Series A-1Convertible Preferred Stock, it would have a material impact on our liquidity,which may require us to obtain additional sources of cash to sustainoperations.

 

Dividends on our redeemable Series A-1Convertible Preferred Stock will be paid from October 16, 2004, the firstanniversary of the October 16, 2003 closing of our redeemable Series AConvertible Preferred Stock private placement, and will be paid quarterlybeginning in the 30-day period following January 31, 2005 at arate of 8 percent per annum, subject to annual increases of 2 percent perannum, not to exceed 12 percent per annum.  Because dividends are not payable during thefirst year the preferred stock is outstanding, we have accrued dividends of$756,000 for the first quarter of fiscal year 2004.  Dividends may be paid in cash or additionalshares of our redeemable Series A-1 Convertible Preferred Stock at ourelection, subject to certain limitations. 

 

Our net accounts receivable balance decreased from$9,282,000 as of October 31, 2003 to $9,151,000 as of January 31,2004.  The majority of our accountsreceivable are current and our allowance for doubtful accounts wasapproximately $231,000 as of January 31, 2004, which

 

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represented approximately2 percent 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 first quarter of fiscal year2004 were not significant.

 

During fiscal year 2003, we expanded our efforts withthe law firms assisting us with our pursuit of our intellectual property claimsand currently expect to devote substantially more financial resources to thiseffort.  In addition to paying fees atreduced hourly rates to these firms, our agreement with the law firms providesthat we will pay the law firms a contingency fee of 20 percent of the proceedsfrom specified events related to the protection of our intellectual propertyrights.  These events may includesettlements, judgments, certain licensing fees, subject to certain exceptions,and a sale of our company during the pendancy of litigation or throughsettlement, subject to agreed upon credits for amounts received as discountedhourly fees and unused retainer fees. Additionally, our agreement with the law firms may also be construed toinclude contingency fee payments in connection with our issuance of equitysecurities, which may harm our results of operations as we anticipate thatthese costs to the law firms will be expensed as incurred.

 

We expect that legal fees for the remaining quartersof fiscal year 2004 paid to the law firms we have engaged to pursue ourintellectual property claims will be consistent to the level of fees incurredduring the first quarter of fiscal year 2004. However, legal expenses could increase over time depending ondevelopments in litigation involving us, and certain events outside of ourcontrol could occur or certain contingent events could take place that wouldrequire 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 into operating leases for ourcorporate offices located in the United States and our international salesoffices.  We have commitments under theseleases that extend through fiscal year 2010. In corporate restructuring activities during fiscal years 2001 through2003, we partially vacated some of these facilities, but still have contractualobligations to continue to make ongoing lease payments for one facility thatwill use available cash.  We have pursuedand will continue to pursue sublease opportunities, as available, to minimizethis use of cash; however, we may not be successful in eliminating or reducingcash expenditures for this facility.

 

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

 
| ** **                   | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1 – 3 years** | ** ** | **More than  3 years** | ** ** |
|------------------------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|------------------------|------------|
|                         |       |      |       |                  |       |                 |       |                   |       |
| Operating lease  obligations |       | $         | 7,399,000  |                  | $          | 3,055,000            |       | $                      | 3,338,000  |   | $ | 1,006,000 |   |
|                              |            |           |            |                       |            |                      |            |                        |            |  |  |  |  |

 

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

 

Our ability to cut costs to offset revenue declines inour UNIX business is limited to a certain extent because of contractualcommitments to maintain and support our existing UNIX customers.  The decline in our UNIX business may beaccelerated if industry partners withdraw

 

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their support as a resultof our SCOsource initiatives and in particular any lawsuits against end usersviolating 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 our UNIX products and services revenue isless than expected, our liquidity will be adversely impacted.  

 

In the event that cash required to fund operations andstrategic initiatives exceeds our current cash resources and cash generatedfrom operations, we will be required to reduce costs and perhaps raiseadditional capital.  We may not be ableto reduce costs in a manner that does not impair our ability to maintain our UNIXbusiness and pursue our SCOsource initiatives. We may also not be able to raise capital for any number of reasonsincluding those listed under the section “Risk Factors” below.  Our ability to raise additional equitycapital is restricted under the terms of our Series A-1 Convertible PreferredStock.  If additional equity financing isavailable, it may not be available to us on attractive terms and may bedilutive to our existing stockholders. Our ability to raise debt financing is restricted under the terms of ourSeries A-1 Convertible Preferred Stock. In addition, if our stock price declines, we may not be able to accessthe public equity markets on acceptable terms, if at all.  Our ability to effect acquisitions for stockwould also be impaired.

 

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

 

If our 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 $272,000 in the aggregate, excluding interestand other possible fees, based upon shares outstanding under the Plans as of January 31,2004.

 

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

 

We may also berequired to pay interest and penalties up to statutory limits in connectionwith Plan participants making rescission claims or in connection with anyrescission offer.  We believe that it isreasonably possible that we may be required to pay interest and penalties, butare not able to estimate an amount.

 

On March 10,2004, our board of directors authorized management, in its discretion, topurchase up to 1,500,000 shares of our common stock over a 24-monthperiod.  Shares may be

 

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purchased in open market transactions, block purchases or privatelynegotiated transactions.  Any repurchasedshares will be held as treasury stock and will be available for generalcorporate purposes.  If we repurchase a substantial number of sharesduring this 24-month period, and we do not generate off-setting revenue formour UNIX and SCOsource businesses, our cash position could decreasesignificantly and our ability to fund future operations could be adverselyimpacted.  Purchases under stockrepurchase program are subject to the discretion of management based on marketconditions and other factors including the trading price of our common stock,availability of stock, alternative uses of capital and our financial condition.

 

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

 

*Foreign Currency Risk. *We have foreign offices andoperations in Europe and Asia.  As aresult, a portion of our revenue is derived from sales to customers outside theUnited States.  Most of this internationalrevenue is denominated in U.S. dollars. However, most of the operating expenses related to our foreign-basedoperations are denominated in foreign currencies and therefore operatingresults are affected by changes in the U.S. dollar exchange rate in relation toforeign currencies such as the Euro, among others.  If the U.S. dollar remains weak compared tothe Euro, our operating expenses for foreign operations will be higher whentranslated back into U.S. dollars.  Ourrevenue can also be affected by general economic conditions in the UnitedStates, Europe and other international markets. Our results of operations may be affected in the short term byfluctuations in foreign currency exchange rates.  

 

We utilize foreign currency forward exchange contractsfor market exposures of underlying assets and liabilities.  We do not use forward exchange contracts forspeculative or trading purposes.  Ouraccounting policies for these instruments are based on our designation of suchinstruments.  The criteria we use fordesignating an instrument include the instrument’s effectiveness in riskreduction and one-to-one matching of forward exchange contracts to underlyingassets and liabilities.  Gains and losseson currency forward contracts that are firm commitments are deferred andrecognized in income in the same period that the underlying transactions aresettled.  Gains and losses on 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 January 31, 2004, we had oneforeign exchange contract with a maturity of approximately 30 days to sell anaggregate of 650,000 United Kingdom pounds for approximately $1,170,000 U.S.dollars.  As of January 31, 2004, wehad no outstanding instruments accounted for as hedges.

 

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

 

*Investment Risk. *We have invested in equity instruments of privatelyheld and public companies in the technology industry for business and strategicpurposes.  Investments are accounted forunder the cost method if our ownership is less than 20 percent and we are notable to exercise influence over operations. Our investment policy is to regularly review the assumptions andoperating performance of these companies and to record impairment losses whenevents and circumstances indicate that these investments may be impaired.  As of January 31, 2004, our investmentsbalance was approximately $488,000.

 

The stock market in general, and the market for sharesof technology companies in particular, has experienced extreme pricefluctuations.  In addition, factors suchas new product introductions by our competitors or developments in thelitigation related to our SCOsource initiatives may have a significant impacton the market price of our common stock. Furthermore,

 

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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.

 

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

 

Under the supervision and with the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, we evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rule 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based upon that evaluation, and subsequentevaluations, the Chief Executive Officer and Chief Financial Officer concludedthat, as of the end of the period covered by this report and as a result of thematerial weakness in our internal controls described below, our disclosurecontrols and procedures were noteffective to ensure that information required to be disclosed by us in thereports we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in applicable rules andforms.

 

We have a material weakness with respect to accountingfor capital stock and stock option transactions.  We have issued certain shares of our commonstock under our equity compensation plans without complying with theregistration requirements of federal and applicable state securities laws.  As a result, the holders of such shares mayhave a rescission right, and, consequently, certain amounts the Companyreceived upon purchase of such shares must be reclassified from permanentequity to temporary equity.  We reclassifiedfrom permanent equity to temporary equity $272,000 related to certain shares ofcommon stock issued under the Company’s equity compensation plans that aresubject to rescission.  We determinedthat we lacked procedures to reconcile shares issued with shares availableunder registration statements in a timely manner.  

 

In addition, we incorrectly accounted for dividends onSeries A Convertible Preferred Stock by not recording dividends payable of$879,000 as of January 31, 2004.  Wehave also understated compensation expense by not properly accounting for anon-routine stock option grant to a non-employee by $233,000 for the threemonths ended January 31, 2004.  Wedetermined that we lacked resources with proper experience to review theCompany’s accounting for capital stock and stock 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 haveimplemented in our internal control procedures additional detail transactionalcontrols, an equity compliance checklist and additional review and approvalprocedures.  

 

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

 

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**Forward-Looking Statements****and Factors That May Affect Future Results and FinancialCondition**

 

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

#### *** ***

•                              Our intentionto maintain our level of investment in and commitment to our UNIX operatingsystems, including investing in research and development efforts during fiscalyear 2004 to enhance our OpenServer and UnixWare products;

 

•                              Ourbelief that the future success of our SCOsource initiatives will depend on ourability to protect our intellectual property, our intention to continue todevote resources to our SCOsource initiatives and our expectation thatquarterly legal fees and other SCOsource related costs for the remainingquarters of fiscal year 2004 will be consistent with the level of costsincurred in the first quarter of fiscal year 2004, although legal expensescould increase depending on developments in our litigation and the occurrenceof certain events outside our control or certain contingent events couldrequire us to pay additional fees to our law firms;

 

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

 

•                              Ourintention to continue to increase our SCOsource sales team in fiscal year 2004;

 

•                              Ourexpectation that SCOsource licensing revenue will increase in future quartersof fiscal year 2004 in the form of vendor licenses 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 first quarter of fiscalyear 2004;

 

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

 

•                              Ourexpectation that the majority of our services revenue will continue to bederived from UNIX-based products, and that our future level of services revenuedepends in part on our ability to generate UNIX products revenue from newcustomers and as well as renew certain annual support and services agreementswith existing UNIX customers;

 

•                              Ourexpectation for the remaining quarters of fiscal year 2004 that our cost ofproducts revenue in dollars will be consistent to cost of products revenueincurred in the first quarter of fiscal year 2004;

 

•                              Ourexpectation for the remaining quarters of fiscal year 2004 that our cost ofSCOsource licensing revenue will be consistent with our cost of SCOsourcelicensing revenue for the first quarter of fiscal year 2004, subject toquarter-to-quarter fluctuations based on unpredictable SCOsource licensingrevenue, the possibility that legal expenses could increase depending ondevelopments in our litigation, and the occurrence of certain events outsideour control or certain contingent events could require us to pay an additionalcontingency fee to our law firms;

 

•                              Ourexpectation for the remaining quarters of fiscal year 2004 that our cost ofservices revenue in dollars will be slightly less than in the first quarter offiscal year 2004;

 

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

 

•                              Ourexpectation for the remaining quarters of fiscal year 2004 that our researchand development expenses in dollars will remain consistent or increase slightlyfrom our expenses incurred in the first quarter of fiscal year 2004;

 

•                              Ourexpectation for the remaining quarters of fiscal year 2004 that our general andadministrative expenses in dollars will decrease compared to our general andadministrative expenses incurred in the first quarter of fiscal year 2004;

 

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

 

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

 

•                              Ourbelief that our legal costs for the remaining quarters of fiscal year 2004 willremain consistent with those incurred in the first quarter of fiscal year 2004,although legal expenses could increase depending on developments in ourlitigation and the occurrence of certain events outside our control or certaincontingent events could require us to pay additional fees to our law firms; 

 

•                              Ouranticipation of recording other income in the second quarter of fiscal year2004 related to the change in the fair value of the derivative between January 31,2004 and February 5, 2004, the time at which the exchange agreement wasexecuted and recording a dividend in the second quarter of fiscal year 2004related to the difference between the fair value of the new redeemable Series A-1Convertible Preferred Stock and the carrying value of the previously issuedredeemable Series A Convertible Preferred Stock and related derivative; 

 

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

 

•                              Ourannounced plan to repurchase up to 1,500,000 shares of our common stock.

 

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

 

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

#### *** ***

*Wedo not have a history of profitable operations.*

 

Our fiscal year ended October 31, 2003 was thefirst full year we were profitable in our operating history.  Our profitability in fiscal year 2003resulted primarily from our SCOsource licensing initiatives.  For the three months ended January 31,2004, we incurred a net loss of $1,730,000 (restated) and our accumulateddeficit as of January 31, 2004 was approximately $202,596,000(restated).  If we do not receiveSCOsource licensing revenue in future quarters and

 

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our revenue from the saleof our UNIX operating system platform products and services continues todecline, we will need to further reduce operating expenses to maintainprofitability or generate positive 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 and the generaleconomic slowdown.  In ourquarterly results of operations, we recognize revenue from agreements forsupport and maintenance contracts and other long-term contracts that have beenpreviously invoiced and are included in deferred revenue.  Our deferred revenue balance increased from$5,501,000 as of October 31, 2003 to $6,952,000 as of January 31,2004, however, this increase in deferred revenue may not continue into futurequarters, which may have a negative impact on our operating system platformproducts revenue.  Our future operatingsystem platform revenue may be adversely impacted and may continue to declineif we are unable to replenish these deferred revenue balances with long-termmaintenance and support contracts or replace them with other sustainablerevenue streams.  If we are unable tocontinue to generate positive cash flow and profitable operations, our operationsmay be adversely impacted.

 

Additionally, we accounted for the issuance of ourredeemable Series A Convertible Preferred Stock from our October 2003private placement by bifurcating the value of the redeemable Series AConvertible Preferred Stock into a preferred stock component and a derivativecomponent.  As of October 31, 2003,the fair value of the derivative was $15,224,000 and the decrease in fair valueof $2,845,000 was recorded as other income in the statement of operations forfiscal year 2003.  As of January 31,2004, we recorded a liability of $11,600,000 as the fair value of thederivative component.  In addition, forthe three months ended January 31, 2004, we recorded a charge of$3,624,000 to other income related to the change in the fair value of thederivative component.  The derivative waseliminated due to certain rights and privileges included in the new redeemable Series A-1Convertible Preferred Stock such as voting rights and rights to boardrepresentation, among others, that were not included in the redeemable Series AConvertible Preferred Stock.  

 

On February 5,2004, we completed an exchange transaction in which each outstanding share ofredeemable Series A Convertible Preferred Stock was exchanged for oneshare of our new redeemable Series A-1 Convertible Preferred Stock. Theexchange transaction eliminated the derivative related to the redeemable Series AConvertible Preferred Stock that was initially recorded as a current liabilityon our balance sheet and eliminates the charge in our quarterly statements ofoperations for the change in the fair value of the derivative related to theredeemable Series A Convertible Preferred Stock.  We anticipate recording other income 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, thetime at which our exchange agreement was executed.  We also anticipate recording a dividend inthe second quarter of fiscal year 2004 related to the difference between thefair value of the new redeemable Series A-1 Convertible Preferred Stockand the carrying value of the previously issued redeemable Series AConvertible Preferred Stock and related derivative.  This dividend will reduce earnings to commonstockholders.

 

*Ourfuture SCOsource licensing revenue is uncertain.*

 

We initiated the SCOsource licensing effort in January 2003to review the status of UNIX licensing and sublicensing agreements. This effortresulted in the execution of two significant vendor license agreements duringthe fiscal year 2003 and generated $25,846,000 in revenue.  During the three months ended January 31,2004, we recorded SCOsource licensing revenue of $20,000 related to theexecution of intellectual property compliance licenses.  Due to a lack of historical experience andthe uncertainties related to SCOsource licensing revenue, we are unable toestimate the amount and timing of future SCOsource licensing revenue, ifany.  If we do

 

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receive revenue from thissource, it may be sporadic and fluctuate from quarter to quarter.  Our SCOsource initiatives are unlikely toproduce stable, predictable revenue for the foreseeable future.  Additionally, the success of theseinitiatives may depend on the strength of our intellectual property rights andcontractual claims regarding UNIX, including, the strength of our claim thatunauthorized UNIX source code and derivatives are prevalent in Linux.

 

*We may not prevail in our legal actions against IBM, Novelland end users, and unintended consequences of our actions against IBM, Novelland end users and other initiatives to assert our intellectual property rightsmay adversely affect our business.*

 

On or about March 6,2003, we filed a complaint against IBM alleging breach of contract,misappropriation of trade secrets, tortious interference, and unfaircompetition. The matter is currently pending in the United States DistrictCourt for the District of Utah. The complaint also alleges that IBM obtainedinformation concerning our UNIX source code and derivative works from us andinappropriately used and distributed that information in connection with itsefforts to promote the Linux operating system.

 

On or about June 16,2003, we filed an amended complaint in the IBM case. The amended complaintessentially restates and realleges the allegations of the original complaintand expands on those claims in several ways. Most importantly, the amendedcomplaint raises new allegations regarding IBM’s actions and breaches throughthe products and services of Sequent, which IBM acquired. We allege that IBMbreached the Sequent agreement in several ways similar to those set forthabove, and we are seeking damages flowing from those breaches. We are alsoseeking injunctive relief on several of our claims.

 

IBM has filed a responseand counterclaim to the complaint, including a demand for jury trial. We havefiled an answer to the IBM counterclaim denying the claims and assertingaffirmative defenses.

 

In its counterclaim, asamended on September 25, 2003, IBM asserts that we do not have the rightto terminate its UNIX license or assert claims based on our ownership of UNIXintellectual property against them or others in the Linux community. Inaddition, they assert that we have infringed on certain patents held by IBM.IBM’s counterclaims include claims for breach of contract, violation of theLanham Act, unfair competition, intentional interference with prospectiveeconomic relations, unfair and deceptive trade practices, breach of the GNUgeneral public license, and patent infringement. Discovery and relateddiscovery motions are ongoing in the case. We intend to vigorously defend thesecounterclaims. On February 4, 2004, we filed a motion for leave to fileamended pleadings in the case proposing to amend our complaint against IBM andto modify our affirmative defenses against IBM’s counterclaims.  On February 25, 2004, the court grantedour motion for leave.  The second amendedcomplaint, which was filed on February 27, 2004, alleges nine causes ofaction that are similar to those set forth above, adds a new claim forcopyright infringement and removes the claim for misappropriation of tradesecrets.  IBM has not yet responded to thesecond amended complaint.

 

If we do not prevail inour action against IBM, or if IBM is successful in its counterclaim against us,our business and results of operations could be materially harmed. Thelitigation with IBM and potentially others could be costly, and our costs forlegal 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 to 1,500 of the world’s largestcorporations, cautioned users of Linux that there are unresolved intellectualproperty issues surrounding Linux that may expose them to unanticipatedliability. As a result of these concerns, we

 

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have suspended our sales of Linux products. We havealso begun delivering written notice to a large number of licensees under ourUNIX contracts requiring them to, among other things, provide writtencertification that they are in full compliance with their agreements, includingcertification that they are not using our proprietary UNIX code in Linux, havenot allowed unauthorized use of licensed UNIX code by their employees orcontractors and have not breached confidentiality provisions relating tolicensed UNIX code. Additionally, we have begun notifying selected Linux endusers in writing of violations we allege under the Digital Millennium CopyrightAct related to our copyrights contained in Linux.

 

As a result of our actionagainst IBM and our 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 SCOsource efforts. Linux proponents havetaken a broad range of actions against us, including, for example, attemptingto influence participants in the markets in which we sell our products toreduce or eliminate the amount of our products and services they purchase fromus. We expect that similar efforts likely will continue. There is a risk thatparticipants in our marketplace will negatively view our action against IBM andour SCOsource initiatives, and we may lose support from such participants.

 

Any of the foregoingcould adversely affect our position in the marketplace, our results ofoperations and our stock price.

 

We have also experiencedseveral denial-of-service attacks on our website, which have prevented webusers from accessing our website and doing business with us for a period oftime. If such attacks continue or if our customers and strategic partners arealso subjected to similar attacks, our business and results of operations couldbe 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 becomesubject to a copyright infringement claims from us. Additionally, Open SourceDevelopment Labs, a non-profit organization (“OSDL”), has established a legaldefense fund that will be used to defend Linux users against copyrightinfringement lawsuits brought by us. It has been reported that OSDL so far hasattracted several million dollars in pledges from contributors including IBMand Intel among others. Similarly, Red Hat, Inc. has announced it hascommitted one million dollars for a separate fund it created to cover the legalexpenses of other companies developing Linux.

 

As a further response toour SCOsource initiatives and claim that our UNIX source code and derivativeworks have inappropriately been included in Linux, Novell has publicly assertedits belief that it owns certain copyrights in our UNIX source code, and it hasfiled 15 copyright applications with the United States Copyright Office relatedto UNIX. Novell also claims that it has a license to UNIX from us and the rightto authorize its customers to use UNIX technology in their internal businessoperations. Specifically, Novell has also claimed to have retained rightsrelated to legacy UNIX SVRx licenses, including the license with IBM. Novellasserts it has the right to take action on behalf of SCO in connection withsuch licenses, including termination rights. Novell has purported to veto ourtermination of the IBM, Sequent and SGI licenses. We have repeatedly assertedthat we obtained the UNIX business, source code, claims and copyrights when weacquired the assets and operations of the server and professional servicesgroups from The Santa Cruz Operation in May 2001, which had previouslyacquired all such assets and rights from Novell in September 1995 pursuantto an asset purchase agreement, as amended.

 

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OnJanuary 20, 2004, in response to Novell’s actions, we brought suit againstNovell for slander of title seeking relief for Novell’s alleged bad faitheffort to interfere with our copyrights related to our UNIX source code andderivative works and our UnixWare products. The case is currently pending before the Third Judicial District Courtin Salt Lake City, Utah. Novell has not yet answered to our complaint but hasfiled with the United States District Court for the District of Utah a noticeremoving the case to such federal court and a motion with the Third JudicialDistrict Court in Salt Lake County, Utah to transfer the venue of the case fromsuch court to the Fourth Judicial District Court in Utah County, Utah. Neithercourt has ruled on these actions. Novell also filed a motion to dismiss ourcomplaint claiming it never transferred the copyrights to The Santa CruzOperation. We have filed a response to Novell’s motion to dismiss and have alsofiled a motion to remand the case back to the state court.  The court has not ruled on thesemotions.  We plan to vigorously pursueits claims against Novell.

 

Amongour allegations in the suit against Novell, we allege that Novell hasimproperly filed copyright registrations in the United States Copyright Officefor UNIX technology covered by our copyrights and has made false and misleadingpublic claims that it, and not our company, owns the UNIX and UnixWarecopyrights. We also allege that Novell has made false statements with theintent to cause customers and potential customers to not do business with usand has attempted, in bad faith, to block our ability to enforce ourcopyrights. Additionally, we allege that Novell’s false and misleadingrepresentations that it owns the UNIX and UnixWare copyrights have caused usirreparable harm to our copyrights, our business, and our reputation.

 

In the lawsuit, we request preliminary and permanentinjunctive relief as well as damages. The injunction would require Novell toassign to us all copyrights that we believe Novell has wrongfully registered,prevent Novell from representing any ownership interest in those copyrights,and require Novell to retract or withdraw all representations it has maderegarding its purported ownership of those copyrights.

 

On orabout March 2, 2004, we brought suit against AutoZone, Inc. (“AutoZone”) forits alleged violations of our UNIX copyrights through its use of Linux.  Specifically, the lawsuit alleges thatAutoZone violated our UNIX copyrights by 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 orabout March 3, 2004, we brought suit against DaimlerChrysler Corporation (“DaimlerChrysler”)for its alleged violations of its UNIX software agreement with us.  Specifically, the lawsuit alleges thatDaimlerChrysler breached its UNIX software agreement with us by failing tocertify by January 31, 2004 its compliance with the UNIX software agreement asrequired by us.  The lawsuit, filed inOakland County Circuit Court in the State of Michigan, requests the court toissue orders declaring 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.

 

Notwithstandingour assertions of full ownership of UNIX-related intellectual property rights,as set forth above, including copyrights, and even if we are successful in ourlegal action against Novell and end users such as AutoZone and DaimlerChrysler,the efforts of Novell and the other Linux proponents described above may causeLinux end users to be less willing to purchase from us our SCOsource IPlicenses authorizing their use of our intellectual property contained in theLinux operating system, which may adversely affect our revenue from ourSCOsource initiatives.

 

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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 to creating confusion in themarketplace about the validity of our claim that the unauthorized use of ourUNIX source code and derivative works in Linux infringes on ourcopyrights.  Increased negative perceptionand potential confusion about our claims in our marketplace could impede ourcontinued pursuit of our SCOsource initiatives and negatively impact ourbusiness. Additionally, if we fail in our lawsuit against Novell and end userssuch as AutoZone and DaimlerChrysler, the negative perception and confusion inour marketplace about our intellectual property rights and claims likely wouldincrease significantly, and the effectiveness of our SCOsource initiativescould be materially harmed.

 

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

 

OurSCOsource initiatives, particularly lawsuits against end users violating ourintellectual property and contractual rights, may cause industry partners,developers and hardware and software vendors to choose not to support orcertify to our UNIX operating system products. This would lead to anaccelerated decline in our UNIX products and services revenue and wouldadversely impact our results of operations and liquidity.

 

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

 

On orabout August 4, 2003, Red Hat filed a complaint against us that iscurrently pending in the United States District Court for the District ofDelaware. Red Hat has asserted that the Linux operating system does notinfringe 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 we have engaged in false advertising inviolation of the Lanham Act, deceptive trade practices, unfair competition,tortious interference with prospective business opportunities, and trade libeland disparagement. We have filed a motion to dismiss the Red Hat complaint, assertingthat Red Hat lacks standing and that no case or controversy exists on which tobase a declaratory judgment. Red Hat has filed an opposition to our motion todismiss, but the court has not ruled on the motion. If Red Hat is successful inits claim against us, our business and results of operations could bematerially harmed.

 

TheAustralian Competition and Consumer Commission (“ACCC”) contacted us inAugust 2003 regarding complaints it has received concerning ourintellectual property claims and our statements regarding the need forcommercial Linux users to obtain a UNIX license. The ACCC further informed usthat it has not made any decision to pursue the complaints it has received ordetermined what, if any, action it will take. We have hired counsel inAustralia and responded to the ACCC’s request for information. We have notheard from the ACCC and it is unknown if future action will be taken.

 

Severalentities in Germany have obtained temporary restraining orders in Germanyprecluding our German subsidiary, from making statements in Germany that, insubstance, disparage Linux, or entities involved in the Linux industry, orimplicate Linux as infringing our intellectual property rights. SCO GmbH hasreceived an administrative fine of 10,000 Euros for a technical violation ofone of the temporary restraining orders. We are currently negotiating with thevarious claimants in Germany over the temporary restraining orders and ouroptions regarding these matters. Informal complaints similar to those raised inGermany have been received from companies in Austria and Poland. We haveresponded to those complaints. It is not known if those complainants will takefuture action.

 

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Inaddition to these above-mentioned actions, other regulators or others in theLinux community may initiate legal actions against us, all of which maynegatively impact our operations or future operating performance.

 

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

 

Fluctuationsin our quarterly operating results or our failure to meet the expectations ofanalysts or investors, even in the short-term, could cause our stock price todecline significantly. Because of the potential for significant fluctuations inour SCOsource licensing revenue in any particular period, you should not relyon quarter-to-quarter comparisons of our results of operations as an indicationof future performance.

 

Factorsthat may affect our results include:

 

•              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 lawsuitsagainst end users violating our intellectual property and contractual rights.

 

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

 

As aresult of the factors listed above and elsewhere, it is possible that ourresults of operations may be below the expectations of public market analystsand investors in any particular period. This could cause our stock price todecline. If revenue falls below our expectations and we are unable to quicklyreduce our spending in response, our operating results will be lower thanexpected. Our stock price may fall in response to these events.

 

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

 

Wehave a two-tiered distribution channel. The relationships we have developedwith resellers allow us to offer our products and services to a much largercustomer base than we would otherwise be able to reach through our own directsales and marketing efforts. Some solution

 

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providers also purchase solutions through our resellers, and weanticipate they will continue to do so. Because we usually sell indirectlythrough resellers, we cannot control the relationships through which resellers,solution providers or equipment integrators purchase our products. In turn, wedo not control the presentation of our products to end-users. Therefore, oursales could be affected by disruptions in the relationships between us and ourresellers, between our resellers and solution providers, or between solutionproviders and end users. Also, resellers and solution providers may choose notto emphasize our products to their customers. Any of these occurrences coulddiminish the effectiveness of our distribution channel and lead to decreasedsales.

 

*Ifthe market for UNIX continues to contract, it may adversely affect ourbusiness.*

 

Ourrevenue from the sale of UNIX-based products has declined over the last fouryears. This decrease in revenue has been attributable primarily to increasedcompetition from other operating systems, particularly Linux, lower informationtechnology spending and the worldwide economic slowdown. If the demand forUNIX-based products continues to decline, and we are unable to develop UNIXproducts and services that successfully address a market demand, our businesswill be adversely affected. Because of the long adoption cycle for operatingsystem purchases and the long sales cycle of our operating system products, wemay not be able to reverse these revenue declines quickly.

 

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

 

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

 

Ourfuture success may depend in part on our ability to continue to meet theincreasing needs of our customers by supporting existing and emergingtechnologies. If we do not enhance our products to meet these evolving needs,we may not remain competitive and be able to grow our business. Additionally,because technological advancement in the UNIX operating system market andalternative operating system markets is at an advanced pace, we will have todevelop and introduce enhancements to our existing products and any newproducts on a timely basis to keep pace with these developments, evolvingindustry standards and changing customer requirements. Our failure to meet anyof these and other competitive pressures may render our existing products andservices obsolete, which would have an adverse impact on our revenue andoperations.

 

Thesuccess of our UNIX business will depend on the level of commitment andcertification we receive from industry partners and developers. In recentyears, we have seen hardware and software vendors as well as softwaredevelopers turn their certification and application development efforts towardLinux and elect not to continue to support or certify to our UNIX operatingsystem products. If this trend continues, our competitive position will beadversely impacted and our future revenue 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 SCOsource initiatives and inparticular any lawsuit against end users violating our intellectual propertyand contractual rights, such as our lawsuits against AutoZone andDaimlerChrysler.

 

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

 

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Ourcompensation arrangement with the law firms representing us in our efforts toestablish our intellectual property rights could inhibit our ability to raiseadditional funding if needed. In addition to receiving fees at reduced hourlyrates, our agreement with the law firms provides that the law firms willreceive a contingency fee of 20 percent of the proceeds from specifiedevents related to the protection of our intellectual property rights. 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, and our agreement with the lawfirms may also be construed to include contingency fee payments in connectionwith issuances of our equity securities. Future payments payable to the lawfirms under this arrangement may be significant. Our law firms’ right toreceive such contingent payments could cause prospective investors to choosenot to invest in our company or limit the price at which new investors would bewilling to provide additional funds to our company.

 

*Ourforeign-based operations and sales create special problems, including theimposition of governmental controls and fluctuations in currency exchange ratesthat could hurt our results.*

 

We haveforeign operations, including development facilities, sales personnel andcustomer support operations in Europe, Latin America and Asia. These foreignoperations are subject to certain inherent risks, including:

 

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

 

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

 

•              fluctuationsin currency exchange rates and economic instability;

 

•              longerpayment cycles for sales in foreign countries;

 

•              seasonalreductions in business activity; and

 

•              politicalunrest, particularly in areas where we have facilities.

 

Inaddition, certain of our operating expenses are denominated in localcurrencies, creating risk of foreign currency translation losses that couldharm our financial results and cash flows. When we generate profits in foreigncountries, our effective income tax rate is increased.

 

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

 

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

 

Duringthe last several quarters the U.S. and European economies have experienced aneconomic slowdown that has affected the purchasing habits of many consumersacross many industries and across many geographies. This has caused the delay,or even cancellation of technology purchases. The slowdown in the United Statesand Europe, together with the alleged unauthorized use of our UNIX code, hasresulted in decreased sales of our products, longer sales cycles and lowerprices. If the current slowdown continues, our revenue and results ofoperations may continue to be lower than expected. In addition, the slowdownmay also affect the end-user market making it more difficult for our resellerchannel to sell our products.

 

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

 

Wewill need to retain our management, technical, and support personnel.Competition for qualified professionals in the software industry is intense,and departures of existing personnel could be disruptive to our business andcan result in the departure of other employees. The loss or departure of anyofficers or key employees could harm our ability to implement our business planand could adversely affect our operations. Our future success depends to asignificant extent on the continued service and coordination of our managementteam, particularly Darl C. McBride, our President and Chief Executive Officer.We do not maintain key person insurance for any 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 inmid-February 2003, to a sales price of $20.50 per share inOctober 2003, to a current sales price of $9.51 on March 10, 2004. Theshare price has changed dramatically over short periods with increases anddecreases of over 25 percent in a single day. We believe that the changes in our stock price are affected by changingpublic perceptions concerning the strength of our intellectual property claimsand other factors beyond our control. Public perception can change quickly and without any change ordevelopment in our underlying business or litigation position.  An investment in our stock is subject to suchvolatility and, consequently, is subject to significant risk.

 

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

 

As ofMarch 1, 2004, we have issued and outstanding options to purchase up toapproximately 3,438,000 shares of common stock with exercise prices rangingfrom $0.66 to $28.00 per share. The existence of such rights to acquire commonstock at fixed prices may prove a hindrance to our efforts to raise futureequity and debt funding, and the exercise of such rights will dilute thepercentage ownership interest of our stockholders and may dilute the value oftheir ownership. The possible future sale of shares issuable on the exercise ofoutstanding options could adversely affect the prevailing market price for ourcommon stock. Further, the holders of the outstanding rights may exercise themat a time when we would otherwise be able to obtain additional equity capitalon terms more favorable to us.

 

*Theholders of shares of redeemable Series A-1 Convertible Preferred Stock havepreferential redemption rights and rights upon liquidation that could adverselyaffect the holders of our common stock.*

 

OnOctober 16, 2003, we completed a $50,000,000 private placement of 50,000shares of our redeemable Series A Convertible Preferred Stock and received netproceeds of approximately $47,740,000. On February 5, 2004, we completed an exchange transaction in whicheach outstanding share of redeemable Series A Convertible Preferred Stock wasexchanged for one share of our new redeemable Series A-1 Convertible PreferredStock.

 

If theholders of shares of redeemable Series A-1 Convertible Preferred Stock choosenot to convert their shares, then, they will be entitled to require us torepurchase for cash all the shares of redeemable Series A-1 ConvertiblePreferred Stock held by them at a premium price if any of several redemptiontrigger events occurs.  These redemptionprovisions, if triggered, would require us to redeem the then-issued and outstandingshares of our redeemable Series A-1 Convertible Preferred Stock for cash.

 

Additionally,the Certificate of Designation for the redeemable Series A-1 ConvertiblePreferred Stock provides that the number of shares of our common stock issuableupon the conversion of shares of redeemable Series A-1 Convertible PreferredStock is limited to 2,863,135

 

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shares in the aggregate, notwithstanding that the holders of shares ofredeemable Series A-1 Convertible Preferred Stock may otherwise be entitled toreceive more shares of common stock upon conversion based on the applicableconversion price. If the number of shares of common stock issuable to theholders of shares of redeemable Series A-1 Convertible Preferred Stock uponconversion is limited in this manner, then we may be required by the holders ofsuch shares to redeem for cash the number of shares of redeemable Series A-1Convertible Preferred Stock that were not issuable upon conversion as a resultof such limits on conversion. If we were required to pay cash to the holders ofshares of our redeemable Series A-1 Convertible Preferred Stock for any reason,it could have a material impact on our liquidity, which may require us toobtain additional sources of cash to sustain operations and may negativelyimpact the holders of our common stock.

 

Further,the holders of shares of our redeemable Series A-1 Convertible Preferred Stockwill 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, the holders of redeemable Series A-1 Convertible Preferred Stock will beentitled to receive the greater of:

 

•              thevalue of the shares of redeemable Series A-1 Convertible Preferred Stock heldby them determined by multiplying the closing sale price of our common stock onThe Nasdaq SmallCap Market on the date of the liquidation event by the numberof shares of common stock into which the preferred shares could be converted atthe time of the liquidation event; or

 

•              upto $50,000,000, the aggregate purchase price paid by the investors in ourOctober 2003 redeemable Series A Convertible Preferred Stock privateplacement, plus eight percent of that amount less the amount of any dividendspaid to the preferred stockholders in the calendar year in which theliquidation event occurs.

 

Dependingon the amount of assets we have available for distribution to stockholders upona liquidation event when shares of redeemable Series A-1 ConvertiblePreferred Stock remain outstanding, we may be required to distribute all suchassets or a portion of such assets that exceeds the preferred stockholders’ prorata ownership of our common stock assuming full conversion of their preferredshares into common stock, which could eliminate or limit the assets availablefor distribution to our common stockholders. Our potential obligation to pay tothe law firms representing us in our efforts to establish our intellectualproperty rights a contingent fee of 20 percent of the proceeds we receivefrom a sale of our company, subject to certain limitations, could alsocontribute to eliminating or limiting the assets available for distribution toour common stockholders.

 

*Therights of holders of shares of redeemable Series A-1 Convertible PreferredStock may prevent or make it more difficult for us to raise additional funds ortake other significant company actions.*

 

TheCertificate of Designation creating our redeemable Series A-1 ConvertiblePreferred Stock requires us to obtain the approval of the holders of a majorityof the then outstanding redeemable Series A-1 Convertible Preferred Stock totake the following actions, among others:

 

•              changethe rights, preferences or privileges of the redeemable Series A-1 ConvertiblePreferred Stock or issue additional shares of redeemable Series A-1 ConvertiblePreferred Stock;

 

•              createor issue any other securities that are senior or equal in rank to theredeemable Series A-1 Convertible Preferred Stock;

 

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•              createor issue any convertible securities having floating conversion rate terms or afixed conversion price below the then applicable conversion price of theredeemable Series A-1 Convertible Preferred Stock or the closing sale price ofour common stock on The Nasdaq SmallCap Market on the date of such issuance;

 

•              incurany indebtedness, subject to limited exceptions; or

 

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

 

TheCertificate of Designation also provides that the holders of our redeemable SeriesA-1 Convertible Preferred Stock have a participation right entitling them topurchase their pro rata share of any future equity securities, or debt that isconvertible into equity, on the same terms offered by us to other purchasers ofsuch securities. Additionally, we have agreed with the holders of ourredeemable Series A-1 Convertible Preferred Stock that we will not complete atransaction or take any action that could result in a claim for a contingencypayment by the law firms representing us in our efforts to establish ourintellectual property rights, other than contingency payments related tocertain license transactions, without first obtaining the consent of theinvestors holding at least two thirds of the shares of our redeemable SeriesA-1 Convertible Preferred Stock. This right of consent, and the participationright and other approval rights described above, may make it more difficult formanagement, our board of directors or our stockholders to reach a settlement inour litigation with IBM, raise capital in the future in either equity or debtfinancing transactions or to take other significant company actions. Theseprovisions could also limit the price that some investors might be willing topay for shares of our common stock in the future.

 

*Theshares of redeemable Series A-1 Convertible Preferred Stock may have an adverseimpact on the market value of our stock and the existing holders of our commonstock.*

 

Wehave filed a prospectus relating to the sale or distribution of up to 3,703,704shares of common stock by certain holders of our redeemable Series A-1Convertible Preferred Stock as selling stockholders. We will not receive anyproceeds from the sales of these shares. The shares subject to the prospectus represent approximately 25.8percent of our issued and outstanding common stock, although no sellingstockholder and its affiliates may beneficially own more than 4.99 percentof our common stock at any time, and, in the aggregate, no more than 2,863,135shares of our common stock may be issued upon the conversion of our outstandingshares of redeemable Series A-1 Convertible Preferred Stock, which number ofshares represents 19.99 percent of the number of shares of our capitalstock outstanding as of February 5, 2004, the date of issuance of ourshares of redeemable Series A-1 Convertible Preferred Stock.  The redeemable Series A-1 ConvertiblePreferred Stock is convertible into shares of our common stock at a variableprice based upon the market price of our common stock, subject to a floor priceof $13.50 per share.  Additionally, thesale of the block of stock covered by this registration statement, or even thepossibility of its sale, may adversely affect the trading market for our commonstock and reduce the price available in that market.  The shares of common stock subject to ourprospectus will, upon issuance, dilute the equity ownership percentage of theholders of our common stock, and if the conversion price of the redeemableSeries A-1 Convertible Preferred Stock decreases, the potential adversedilution for our holders of common stock will increase. The market price of ourcommon stock also could decline as a result of the perception or expectationthat sales of a large number of shares of our common stock could occur followingthe conversion of our redeemable Series A-1 Convertible Preferred Stock.

 

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

 

Ourboard of directors currently has the right, with respect to the 4,840,000shares of our preferred stock not designated as either 80,000 shares ofredeemable Series A Convertible Preferred

 

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Stock or 80,000 shares of redeemable Series A-1 Convertible PreferredStock, to authorize the issuance of one or more additional series of ourpreferred stock with such voting, dividend and other rights as our directorsdetermine. We further anticipate that we will terminate the redeemable Series AConvertible Preferred Stock, which, upon such termination, will cause thenumber of shares of preferred stock not designated to increase to 4,920,000shares. 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 our holders of redeemable Series A-1 Convertible PreferredStock as described above. The rights of holders of our common stock may beadversely affected by the rights of any holders of additional shares ofpreferred stock that may be issued in the future, including without limitation,further dilution of the equity ownership percentage of our holders of commonstock and their voting power if we issue preferred stock with voting rights. Additionally,the issuance of preferred stock could make it more difficult for a third partyto acquire a majority of our outstanding voting stock.

 

*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 issued certain shares and grantedoptions under the Plans (as previously defined in Part I, Item 1 of thisAmendment No. 1 to Form 10-Q/A) without complying with registration orqualification requirements under federal securities laws and the securitieslaws of certain states.  As a result,certain Plan participants that have acquired shares issued under the Plans haverescission rights against us, subject to applicable statutes of limitations,and we may, subject to obtaining required regulatory approvals, make arescission 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 ourpotential rescission offer is made and accepted by Plan participants holdingshares acquired under the Plans or otherwise entitled to recover damages fromus in respect of such shares they have sold, or such Plan participantsotherwise make rescission claims against us, we could be liable to makeaggregate payments to these Plan participants of up to $272,000 in theaggregate, excluding interest and other possible fees, based upon sharesoutstanding under the Plans as of January 31, 2004.

 

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

 

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

 

**ITEM 1.****  LEGAL PROCEEDINGS**

 

*IBM Corporation*

 

On or about March 6,2003, we filed a complaint against IBM. This action is currently pending in theUnited States District Court for the District of Utah, under the title *The SCO Group, Inc. vs. International BusinessMachines Corporation*, Civil No. 2:03CV0294.  The complaint includes claims for breach ofcontract, misappropriation of trade secrets, tortious interference, and unfaircompetition. The complaint also alleges that IBM obtained information concerningthe UNIX

 

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source code and derivative works from us and inappropriately used anddistributed that information in connection with its efforts to promote theLinux operating system.  As a result ofIBM’s breach of contract and unfair competition and the marketplace injurysustained by us, we are requesting damages in an amount to be proven at trial,but no less than $1 billion, together with additional damages through and afterthe time of trial. On or about June 13, 2003, we delivered to IBM a notice oftermination of IBM’s UNIX license agreement with us that underlies IBM’s AIXsoftware.

 

On or about June 16,2003, we filed an amended complaint in the IBM case. The amended complaintessentially restates and re-alleges the allegations of the original complaintand expands on those claims in several ways. Most importantly, the amended complaint raises new allegations regardingIBM’s actions and breaches through the products and services of SequentComputer Systems, Inc. (“Sequent”), which IBM acquired.  We allege that IBM breached the Sequentagreement in several ways similar to those set forth above and we seek damagesfor those breaches.  We are also seekinginjunctive 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.

 

In itscounterclaim, as amended on September 25, 2003, IBM asserts that we do not havethe right to terminate its UNIX license or assert claims based on our ownershipof UNIX intellectual property against them or others in the Linuxcommunity.  In addition, IBM asserts wehave breached the GNU General Public License and have infringed certain patentsheld by IBM. IBM’s counterclaims include claims for breach of contract,violation of the Lanham Act, unfair competition, intentional interference withprospective economic relations, unfair and deceptive trade practices,promissory estoppel, copyright infringement and patent infringement.  Discovery is ongoing in the case. We intendto vigorously defend these counterclaims.

 

OnFebruary 4, 2004, we filed a motion for leave to file amended pleadings inthe case proposing to amend our complaint against IBM and to modify ouraffirmative defenses against IBM’s counterclaims.  OnFebruary 25, 2004, the court granted our motion for leave.  The second amended complaint, which was filedon February 27, 2004, alleges nine causes of action that are similar to thoseset forth above, adds a new claim for copyright infringement and removes theclaim for misappropriation of trade secrets. IBM has not yet responded to the second amended complaint.

 

*Red Hat,Inc.*

 

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

 

On or about September 15,2003, we filed a motion to dismiss the Red Hat complaint.  The motion to dismiss asserts that Red Hatlacks standing and that no case or controversy exists with respect to theclaims seeking a declaratory judgment of non-infringement.  The motion to dismiss further asserts thatRed Hat’s claims under the Lanham Act and related state laws are barred by theFirst Amendment to the U.S. Constitution and the common law privilege ofjudicial

 

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immunity. Red Hat has filed an opposition to our motion to dismiss, butthe court has not ruled on the motion. We intend to vigorously defend thisaction.

 

*Novell,Inc.*

 

On January 20, 2004, wefiled suit against Novell, Inc. for slander of title seeking relief for itsalleged bad faith effort to interfere with our copyrights related to our UNIXsource code and derivative works and our UnixWare products.  The case is currently pending in the ThirdJudicial District Court, Salt Lake County, State of Utah, under the caption *The SCO Group, Inc. v. Novell, Inc.*, Case No. 040900936.  Novell hasnot yet responded to our complaint but has filed with the United StatesDistrict 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 Fourth JudicialDistrict Court in Utah County, Utah. Neither court has ruled on these actions.Novell also filed a motion to dismiss our complaint claiming it nevertransferred the copyrights to The Santa Cruz Operation. We have filed aresponse to Novell’s motion to dismiss and have also filed a motion to remandthe case back to the state court.  Thecourt has not ruled on these motions.  Weplan to vigorously pursue its claims against Novell.

 

Among our allegations inthe suit against Novell, we allege that Novell has improperly filed copyrightregistrations in the United States Copyright Office for UNIX technology coveredby our copyrights and has made false and misleading public claims that it, andnot our company, owns the UNIX and UnixWare copyrights.  We also allege that Novell has made falsestatements with the intent to cause customers and potential customers to not dobusiness with us and has attempted, in bad faith, to block our ability toenforce our copyrights. Additionally, we allege that Novell’s false andmisleading representations that it owns the UNIX and UnixWare copyrights havecaused us irreparable harm to our copyrights, our business, and our reputation.

 

In the lawsuit, we requestpreliminary and permanent injunctive relief as well as damages. The injunctionwould require Novell to assign to us all copyrights that we believe Novell haswrongfully registered, prevent Novell from representing any ownership interestin those copyrights, and require Novell to retract or withdraw allrepresentations it has made regarding its purported ownership of thosecopyrights.

 

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*AutoZone,Inc.*

 

On orabout March 2, 2004, we brought suit against AutoZone, Inc. for its allegedviolations of our UNIX copyrights through its use of Linux.  Specifically, the lawsuit alleges thatAutoZone violated our UNIX copyrights by running versions of the Linuxoperating system that contain code, structure, sequence and/or organizationfrom our proprietary 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.

 

*DaimlerChryslerCorporation*

 

On orabout March 3, 2004, we brought suit against DaimlerChrysler Corporation forits alleged violations of its UNIX software agreement with us.  Specifically, the lawsuit alleges thatDaimlerChrysler breached its UNIX software agreement with us by failing tocertify its compliance with the UNIX software agreement as required by us byJanuary 31, 2004.  The lawsuit, filed inOakland County Circuit Court in the State of Michigan, requests the court toissue orders declaring 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.

 

*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, theissuers and the insurance companies have negotiated a Memorandum ofUnderstanding (“MOU”) with the intent of settling the dispute between theplaintiffs and the issuers.  We haveexecuted this MOU and have been advised that almost all (if not all) of theissuers have elected to proceed under the MOU. The MOU is still subject to court approval and the preparation ofappropriate settlement documents.  If thesettlement is approved by the court and settlement agreements can be enteredinto by the parties, and if no cross-claims, counterclaims or third partyclaims are later asserted, this action will be dismissed with respect to us andits individuals.

 

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 $200,000 underits insurance coverage.

 

*Other Matters*

 

In April 2003, a former Indian distributor of oursfiled a claim in India, requesting summary judgment for payment of $1,428,000,and an order that we trade in India only through the distributor until theclaim is paid. The distributor claims that we are responsible to repurchasecertain software products and to reimburse the distributor for certain otheroperating costs.  We do not believe thatwe are responsible to reimburse the distributor for any operating costs andalso believe that the return rights related to any remaining inventory havelapsed.  We have engaged local counselwho has advised that it is likely that the current claims will fail, but thatthe distributor will continue to pursue its claims either in the Indian courtsor in the U.S. courts.  Discovery hascommenced and initial hearings have been held. We intend to vigorously defend this action.

 

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

 

**ITEM2.****  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS**

 

This item has beenincluded in connection with the restatement of the Financial Statements asdiscussed further in the Explanatory Note and in Note 2 to the FinancialStatements.

 

As discussed elsewhere above in Part I, Item 1 ofthis Amendment No. 1 to Form 10-Q/A, during the quarter ended January 31, 2004,we issued shares and granted options under the Plans without complying with registrationor qualification requirements under federal securities laws and the securitieslaws of certain states.  As a result,certain Plan participants have a right to rescind their purchases of sharesunder the Plans or recover damages if they no longer own the shares or holdunexercised options, subject to applicable statutes of limitations, and we maymake a rescission offer to certain of such Plan participants subject toobtaining required regulatory approvals. Additionally, regulatory authorities may require us to pay fines or theymay impose other sanctions on us, and we may face other claims by Planparticipants other than rescission claims.

 

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

 

(a)           Exhibits

 

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

 

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

 

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

 

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

 

3.5           Certificateof Designation for Series A Convertible Preferred Stock (incorporated byreference to Exhibit 3.1 to SCO’s Current Report on Form 8-K filed on October17, 2003 (File No. 000-29911)).

 

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

 

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

 

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10.1         LetterAmending 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 CurrentReport on Form 8-K filed on December 9, 2003 (File No. 000-29911)).

 

10.2         LetterAgreement dated December 8, 2003 among SCO, BayStar Capital II, L.P., RoyalBank of Canada and Boies, Schiller & Flexner LLP (incorporated by referenceto Exhibit 99.3 to SCO’s Current Report on Form 8-K filed on December 9, 2003(File No. 000-29911)).

 

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

 

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

 

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

 

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

 

(b)           Reports on Form 8-K

 

On November 5, 2003, wefiled a Current Report on Form 8-K announcing the appointment of Daniel W.Campbell to our Board of Directors.

 

On November 18, 2003, wefiled a Current Report on Form 8-K announcing we had expanded our agreementwith the law firms representing us in our intellectual property claims.

 

On November 19, 2003, wefiled a Current Report on Form 8-K announcing we had filed certain agreementsrelated to the Asset Purchase between The Santa Cruz Operation, Inc. andNovell, Inc.

 

On December 9, 2003, wefiled a Current Report on Form 8-K announcing we had entered into a letteragreement with the two investors in our Series A Convertible Preferred Stockfinancing.

 

On December 22, 2003, wefiled a Current Report on Form 8-K announcing our fourth quarter and fiscalyear 2003 operating results.

 

On January 13, 2004, wefiled a Current Report on Form 8-K announcing a Notice of Compliance with aCourt Order, filed with the United States District Court for the District ofUtah on January 12, 2004.

 

On January 21, 2004, wefiled a Current Report on Form 8-K announcing we had filed suit against Novell,Inc. for its alleged bad faith effort to interfere with our rights with respectto UNIX and UnixWare.

 

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**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 B. Young |   |
|                     |                | Bert B. Young |
|                     |                | Duly Authorized Officer and |
|                     |                | Chief Financial Officer |
|                     |                | (Principal Financial and  Accounting Officer) |

 

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**EXHIBIT INDEX**

** **
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                                                                       |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                    |
| 3.1                 |       | Amended and Restated  Certificate of Incorporation of Caldera International, Inc. (incorporated by  reference to Exhibit 3.1 to SCO’s Registration Statement on Form 8-A12G/A  (File No. 000-29911)).                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                          |
| 3.2                 |       | Certificate of  Amendment to Amended and Restated Certificate of Incorporation regarding  consolidation of outstanding shares (incorporated by reference to Exhibit 3.2  to SCO’s Registration Statement on  Form 8-A12G/A (File No. 000-29911)).                                                                        |
|                |       |                                                                                                                                                                                                                                                                                                                          |
| 3.3                 |       | Certificate of  Amendment to Amended and Restated Certificate of Incorporation regarding  change of name to The SCO Group, Inc. (incorporated by reference to Exhibit  3.3 to SCO’s Registration Statement on Form 8A12G/A (File No. 000-29911)).                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                          |
| 3.4                 |       | Amended and Restated  Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s Registration  Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                          |
| 3.5                 |       | Certificate of  Designation for Series A Convertible Preferred Stock (incorporated by  reference to Exhibit 3.1 to SCO’s Current Report on Form 8-K filed on October  17, 2003 (File No. 000-29911)).                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                          |
| 3.6                 |       | 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)).                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                          |
| 3.7                 |       | 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)).                                               |
|                |       |                                                                                                                                                                                                                                                                                                                          |
| 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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