**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 
| **(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,  2005**                                                                                                                                                                |
|                                                                                                                                                                                                                     |       |       |
| **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 and zip code)           |
|                                                             |       |                                     |
| **(801) 765-4999**                                               |
| (Registrant’s telephone  number, including area code)       |

 

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tofiling requirements for the past 90 days.

 

YES ý NO o

 

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

 

YESo NO ý

 

As of April 12, 2005, there were 17,915,292shares of the Registrant’s common stock, $0.001 par value per share,outstanding.

 

 

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**The SCOGroup, Inc.**

 

**Table of Contents**

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

 

2

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONSOLIDATED BALANCE SHEETS**

**(inthousands)**

 
| ** **                                                                                                    | ** ** | **January 31,  2005** | ** ** | **October 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                                                                                    | ** ** | **(unaudited)**            | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                    | ** ** | ** **                 | ** ** | ** **                 | ** ** |
|                                                                                                          |       |                       |       |                       |       |
| CURRENT ASSETS:                                                                                               |       |                       |       |                       |       |
| Cash and cash equivalents                                                                                     |       | $                          | 9,486      |                       | $          | 12,693 |   |
| Restricted cash                                                                                               |       | 5,402                      |       | 8,283                      |       |
| Available-for-sale securities                                                                                 |       | 5,946                      |       | 18,756                     |       |
| Accounts receivable, net of allowance for doubtful  accounts of $152 and $136, respectively                   |       | 5,953                      |       | 6,638                      |       |
| Other current assets                                                                                          |       | 1,967                      |       | 1,870                      |       |
| Total current assets                                                                                          |       | 28,754                     |       | 48,240                     |       |
|                                                                                                          |       |                       |       |                       |       |
| PROPERTY AND EQUIPMENT:                                                                                       |       |                       |       |                       |       |
| Computer and office equipment                                                                                 |       | 1,988                      |       | 2,991                      |       |
| Leasehold improvements                                                                                        |       | 419                        |       | 406                        |       |
| Furniture and fixtures                                                                                        |       | 94                         |       | 103                        |       |
|                                                                                                          |       | 2,501                      |       | 3,500                      |       |
| Less accumulated depreciation and amortization                                                                |       | (1,909                     | )          | (2,851                     | )          |
| Net property and equipment                                                                                    |       | 592                        |       | 649                        |       |
|                                                                                                          |       |                       |       |                       |       |
| OTHER ASSETS:                                                                                                 |       |                       |       |                       |       |
| Intangibles, net                                                                                              |       | 4,737                      |       | 5,413                      |       |
| Other assets                                                                                                  |       | 1,115                      |       | 1,098                      |       |
| Total other assets                                                                                            |       | 5,852                      |       | 6,511                      |       |
|                                                                                                          |       |                       |       |                       |       |
| Total assets                                                                                                  |       | $                          | 35,198     |                       | $          | 55,400 |   |
|                                                                                                          |       |                       |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                 | ** ** | ** **                 | ** ** | ** **                 | ** ** |
|                                                                                                          |       |                       |       |                       |       |
| CURRENT LIABILITIES:                                                                                          |       |                       |       |                       |       |
| Accounts payable                                                                                              |       | $                          | 1,378      |                       | $          | 7,854 |   |
| Payable to Novell, Inc.                                                                                  |       | 604                        |       | 3,283                      |       |
| Accrued compensation to law firms                                                                             |       | —                     |       | 7,956                      |       |
| Accrued payroll and benefits                                                                                  |       | 2,266                      |       | 3,369                      |       |
| Accrued liabilties                                                                                            |       | 3,827                      |       | 3,855                      |       |
| Deferred revenue                                                                                              |       | 5,519                      |       | 4,877                      |       |
| Other royalties payable                                                                                       |       | 285                        |       | 354                        |       |
| Taxes payable                                                                                                 |       | 1,062                      |       | 1,279                      |       |
| Total current liabilities                                                                                     |       | 14,941                     |       | 32,827                     |       |
|                                                                                                          |       |                       |       |                       |       |
| LONG-TERM LIABILITIES                                                                                         |       | 343                        |       | 343                        |       |
|                                                                                                          |       |                       |       |                       |       |
| COMMITMENTS AND CONTINGENCIES (Note 4)                                                                        |       |                       |       |                       |       |
|                                                                                                          |       |                       |       |                       |       |
| COMMON STOCK SUBJECT TO RESCISSION (Note 5)                                                                   |       | 893                        |       | 528                        |       |
|                                                                                                          |       |                       |       |                       |       |
| STOCKHOLDERS’ EQUITY:                                                                                    |       |                       |       |                       |       |
| Common stock, $0.001 par value; 45,000 shares  authorized, 18,201 and 17,956 shares outstanding, respectively |       | 18                         |       | 18                         |       |
| Additional paid-in capital                                                                                    |       | 246,479                    |       | 246,273                    |       |
| Common stock held in treasury; 290 shares,  respectively                                                      |       | (2,414                     | )          | (2,414                     | )          |
| Warrants outstanding                                                                                          |       | 1,099                      |       | 1,099                      |       |
| Deferred compensation                                                                                         |       | (7                         | )          | (22                        | )          |
| Accumulated other comprehensive income                                                                        |       | 1,023                      |       | 964                        |       |
| Accumulated deficit                                                                                           |       | (227,177                   | )          | (224,216                   | )          |
| Total stockholders’ equity                                                                               |       | 19,021                     |       | 21,702                     |       |
|                                                                                                          |       |                       |       |                       |       |
| Total liabilities and stockholders’ equity                                                               |       | $                          | 35,198     |                       | $          | 55,400 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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

 

**CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS**

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

 
| ** **                                                                                       | ** ** | **Three Months Ended January 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| ** **                                                                                       | ** ** | **(unaudited)**                         | ** ** |
| REVENUE:                                                                                         |       |                                    |       |   |   |
| Products                                                                                         |       | $                                       | 7,304      |   | $ | 9,712 |   |
| SCOsource licensing                                                                              |       | 70                                      |       | 20 |   |
| Services                                                                                         |       | 1,491                                   |       | 1,660 |   |
| Total revenue                                                                                    |       | 8,865                                   |       | 11,392 |   |
|                                                                                             |       |                                    |       |   |   |
| COST OF REVENUE:                                                                                 |       |                                    |       |   |   |
| Products                                                                                         |       | 644                                     |       | 805 |   |
| SCOsource licensing (inclusive of amortization of  intangibles of $83 and $83, respectively)     |       | 3,493                                   |       | 3,523 |   |
| Services                                                                                         |       | 749                                     |       | 1,322 |   |
| Total cost of revenue                                                                            |       | 4,886                                   |       | 5,650 |   |
|                                                                                             |       |                                    |       |   |   |
| GROSS MARGIN                                                                                     |       | 3,979                                   |       | 5,742 |   |
|                                                                                             |       |                                    |       |   |   |
| OPERATING EXPENSES:                                                                              |       |                                    |       |   |   |
| Sales and marketing (exclusive of stock-based  compensation of $7 and $18, respectively)         |       | 2,937                                   |       | 5,021 |   |
| Research and development (exclusive of stock-based  compensation of $8 and $12, respectively)    |       | 2,080                                   |       | 2,707 |   |
| General and administrative (exclusive of stock-based  compensation of $0 and $405, respectively) |       | 1,763                                   |       | 2,194 |   |
| Amortization of intangibles                                                                      |       | 593                                     |       | 787 |   |
| Stock-based compensation                                                                         |       | 15                                      |       | 435 |   |
| Total operating expenses                                                                         |       | 7,388                                   |       | 11,144 |   |
|                                                                                             |       |                                    |       |   |   |
| LOSS FROM OPERATIONS                                                                             |       | (3,409                                  | )          | (5,402 | ) |
|                                                                                             |       |                                    |       |   |   |
| EQUITY IN INCOME OF AFFILIATE                                                                    |       | 53                                      |       | 37 |   |
|                                                                                             |       |                                    |       |   |   |
| OTHER INCOME (EXPENSE):                                                                          |       |                                    |       |   |   |
| Interest income                                                                                  |       | 37                                      |       | 270 |   |
| Change in fair value of derivative                                                               |       | —                                  |       | 3,624 |   |
| Other expense, net                                                                               |       | 472                                     |       | (131 | ) |
| Total other income (expense, net)                                                                |       | 509                                     |       | 3,763 |   |
|                                                                                             |       |                                    |       |   |   |
| LOSS BEFORE INCOME TAXES                                                                         |       | (2,847                                  | )          | (1,602 | ) |
|                                                                                             |       |                                    |       |   |   |
| PROVISION FOR INCOME TAXES                                                                       |       | (114                                    | )          | (128 | ) |
|                                                                                             |       |                                    |       |   |   |
| NET LOSS                                                                                         |       | (2,961                                  | )          | (1,730 | ) |
|                                                                                             |       |                                    |       |   |   |
| DIVIDENDS ON REDEEMABLE CONVERTIBLE PREFERRED STOCK                                              |       | —                                  |       | (756 | ) |
|                                                                                             |       |                                    |       |   |   |
| NET LOSS APPLICABLE TO COMMON STOCKHOLDERS                                                       |       | $                                       | (2,961     | ) | $ | (2,486 | ) |
|                                                                                             |       |                                    |       |   |   |
| BASIC AND DILUTED NET LOSS PER COMMON SHARE                                                      |       | $                                       | (0.17      | ) | $ | (0.18 | ) |
|                                                                                             |       |                                    |       |   |   |
| WEIGHTED AVERAGE BASIC AND DILUTED COMMON SHARES  OUTSTANDING                                    |       | 17,751                                  |       | 13,824 |   |
|                                                                                             |       |                                    |       |   |   |
| OTHER COMPREHENSIVE LOSS                                                                         |       |                                    |       |   |   |
| Net loss                                                                                         |       | $                                       | (2,961     | ) | $ | (1,730 | ) |
| Unrealized gain (loss) on available-for-sale  securities                                         |       | (3                                      | )          | (19 | ) |
| Foreign currency translation adjustment                                                          |       | 62                                      |       | 10 |   |
| COMPREHENSIVE LOSS                                                                               |       | $                                       | (2,902     | ) | $ | (1,739 | ) |

 

See accompanying notes to consolidated financial statements.

 

4

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

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                   | ** ** | **Three Months Ended January 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| ** **                                                                   | ** ** | **(unaudited)**                         | ** ** |
|                                                                         |       |                                    |       |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        |       |                                    |       |   |   |
| Net loss                                                                     |       | $                                       | (2,961     | ) | $ | (1,730 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                                    |       |   |   |
| Amortization of intangibles                                                  |       | 676                                     |       | 871 |   |
| Depreciation and amortization                                                |       | 94                                      |       | 252 |   |
| Stock-based compensation                                                     |       | 15                                      |       | 435 |   |
| Loss on disposal of assets                                                   |       | 14                                      |       | — |   |
| Equity in income of affiliates                                               |       | (53                                     | )          | (37 | ) |
| Change in fair value of derivative                                           |       | —                                  |       | (3,624 | ) |
| Changes in operating assets and liabilities:                                 |       |                                    |       |   |   |
| Restricted cash                                                              |       | 202                                     |       | — |   |
| Accounts receivable, net                                                     |       | 685                                     |       | 131 |   |
| Other current assets                                                         |       | (97                                     | )          | 586 |   |
| Other assets                                                                 |       | 36                                      |       | (202 | ) |
| Accounts payable                                                             |       | (6,476                                  | )          | (560 | ) |
| Accrued payroll and benefits                                                 |       | (1,103                                  | )          | (1,169 | ) |
| Compensation to law firms                                                    |       | (7,956                                  | )          | (2,600 | ) |
| Accrued liabilities                                                          |       | (28                                     | )          | 1,855 |   |
| Deferred revenue                                                             |       | 642                                     |       | 1,451 |   |
| Other royalties payable                                                      |       | (69                                     | )          | (215 | ) |
| Taxes payable                                                                |       | (217                                    | )          | 167 |   |
| Other long-term liabilities                                                  |       | —                                  |       | 70 |   |
| Net cash used in operating activities                                        |       | (16,596                                 | )          | (4,319 | ) |
|                                                                         |       |                                    |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |       |                                    |       |   |   |
| Purchase of property and equipment                                           |       | (45                                     | )          | (131 | ) |
| Purchase of available-for-sale securities                                    |       | (5,600                                  | )          | (14,989 | ) |
| Proceeds from available-for-sale securities                                  |       | 18,410                                  |       | 1,368 |   |
| Net cash provided by (used in) investing activities                          |       | 12,765                                  |       | (13,752 | ) |
|                                                                         |       |                                    |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |       |                                    |       |   |   |
| Proceeds from sale of common stock through employee  stock purchase program  |       | 373                                     |       | 370 |   |
| Proceeds from exercise of common stock options                               |       | 198                                     |       | 297 |   |
| Net cash provided by financing activities                                    |       | 571                                     |       | 667 |   |
|                                                                         |       |                                    |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                         |       | (3,260                                  | )          | (17,404 | ) |
| EFFECT OF FOREIGN EXCHANGE RATES ON CASH                                     |       | 53                                      |       | (33 | ) |
| CASH AND CASH EQUIVALENTS, beginning of period                               |       | 12,693                                  |       | 64,428 |   |
| CASH AND CASH EQUIVALENTS, end of period                                     |       | $                                       | 9,486      |   | $ | 46,991 |   |
|                                                                         |       |                                    |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                            |       |                                    |       |   |   |
|                                                                         |       |                                    |       |   |   |
| Cash paid for taxes                                                          |       | $                                       | 196        |   | $ | 67 |   |
|                                                                         |       |                                    |       |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND  FINANCING ACTIVITIES:   |       |                                    |       |   |   |
|                                                                         |       |                                    |       |   |   |
| Accretion of dividends                                                       |       | $                                       | —     |   | $ | 756 |   |
|                                                                         |       |                                    |       |   |   |
| Common stock subject to rescission                                           |       | $                                       | 893        |   | $ | 272 |   |

 

See accompanying notes to consolidated financial statements.

 

5

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

 

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

## **(1) ORGANIZATIONAND DESCRIPTION OF BUSINESS**

 

The business of The SCO Group, Inc.(the “Company”) 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 business and launched its first of severalSCOsource initiatives to review and enforce its intellectual propertysurrounding the UNIX operating system. The Company acquired certainintellectual property rights surrounding UNIX and UNIX System V source codefrom The Santa Cruz Operation (now Tarantella, Inc.) in May 2001.

 

During the three months ended January 31, 2005,the Company used cash of $16,596,000 in its operations.  The majority of this cash was used to payaccounts payable and accrued liabilities related to the Company’s intellectualproperty litigation.  As of January 31,2005, the Company had a total of $15,432,000 in cash and cash equivalents andavailable-for-sale securities and an additional $4,798,000 as restricted cashto be used in its operations and pursue its intellectual propertylitigation.  As a result of theEngagement Agreement between the Company and the law firms representing it inits intellectual property litigation, the Company anticipates using cash ofapproximately $11,000,000 in the defense of its intellectual propertylitigation during the remainder of the year ending October 31, 2005, whichwould leave the Company approximately $9,230,000 in cash for its businessoperations.  The Company expects that itsUNIX business will generate sufficient cash in the year ending October 31,2005 to cover its internal costs related to its SCOsource initiatives andintellectual property litigation, and believes that it will have sufficientcash resources to fund its operations through October 31, 2005.

 

In the event that cash required to fund operations andstrategic initiatives exceeds the Company’s current cash resources and cashgenerated from operations, the Company will be required to reduce costs andperhaps raise additional capital.  TheCompany may not be able to reduce costs in a manner that does not impair itsability to maintain its UNIX business and pursue its SCOsourceinitiatives.  The Company may also havedifficulty raising capital.  If additionalequity financing is available, it may not be available to the Company onattractive terms and may be dilutive to the Company’s existingstockholders.  In addition, if theCompany’s stock price declines, it may not be able to access the public equitymarkets on acceptable terms, if at all. The Company’s ability to effect acquisitions for stock would also beimpaired.

 

## **(2) SIGNIFICANTACCOUNTING POLICIES**

## ** **

### **Basis of Presentation**

### ** **

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

 

6

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annual financial statements and the notes theretoincluded in the Company’s most recent annual report on Form 10-K,are adequate to make the information presented not misleading.  Operating results for the three months ended January 31,2005 are not necessarily indicative of the results that may be expected for theyear ending October 31, 2005.

 

### **Use of Estimates in thePreparation of Financial Statements**

### ** **

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period.  Actual results could differ from theseestimates.  The Company’s criticalaccounting policies and estimates include, among others, revenue recognition,allowances for doubtful accounts receivable, severance and exit costs,impairment of long-lived assets, and valuation allowances against deferredincome tax assets.

 

### **Revenue Recognition**

### ** **

The Company recognizes revenue in accordance withStatement of Position (“SOP”) 97-2, as modified by SOP 98-9.  The Company’s revenue is primarily from threesources: (i) product license revenue, primarily from product sales toresellers, end users and original equipment manufacturers (“OEMs”); (ii) technicalsupport service revenue, primarily from providing technical support andconsulting services to end users; and (iii) licensing revenue from itsSCOsource intellectual property initiative.

 

The Company recognizes product revenue upon shipmentif a signed contract exists, the fee is fixed or determinable, collection ofthe resulting receivable is probable and product returns are reasonablyestimable.

 

The majority of the Company’s revenue transactionsrelate to product-only sales.  Onoccasion, the Company has revenue transactions that have multiple elements(such as software products, maintenance, technical support services, and otherservices).  For software agreements thathave multiple elements, the Company allocates revenue to each component of thecontract based on the relative fair value of the elements.  The fair value of each element is based onvendor specific objective evidence (“VSOE”). VSOE is established when such elements are sold separately.  The Company recognizes revenue when thecriteria for product revenue recognition set forth above have been met.  If VSOE of all undelivered elements exists,but VSOE does not exist for one or more delivered elements, then revenue isrecognized using the residual method. Under the residual method, the fair value of the undelivered elements isdeferred and the remaining portion of the license fee is recognized as revenuein the period when persuasive evidence of an arrangement is obtained assumingall other revenue recognition criteria are met.

 

The Company recognizes product revenue from OEMs whenthe software is sold by the OEM to an end-user customer.  Revenue from technical support services andconsulting services is recognized as the related services are performed.  Revenue for maintenance is recognized ratablyover the maintenance period.

 

The Company considers an arrangement with paymentterms longer than the Company’s normal business practice, which do not extendbeyond 12 months, not to be fixed and determinable and revenue is recognizedwhen the fee becomes due.  The Companytypically provides stock rotation rights for sales made through its distributionchannel and sales to distributors are recognized upon shipment by thedistributor to end users.  For directsales not through the Company’s distribution channel, sales are typicallynon-refundable and non-cancelable.  TheCompany estimates its product returns based on historical experience and

 

7

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maintains an allowance for estimated returns, which isrecorded as a reduction to accounts receivable.

 

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

 

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

 

The Company accounts for stock options issued todirectors, officers and employees under Accounting Principles Board (“APB”) No. 25,“Accounting for Stock Issued to Employees, and Related Interpretations.”  Under APB No. 25, compensation expenseis recognized if an option’s exercise price on the measurement date is belowthe fair market value of the Company’s common stock.  The Compensation expense, if any, isamortized to expense over the vesting period.

 

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 prescribedby SFAS No. 123, “Accounting for Stock-Based Compensation.”  The fair value for the Company’s stockoptions is estimated on the date of grant using the Black-Scholesoption-pricing model.

 

With respect to stock optionsand restricted stock awards granted and shares purchased pursuant to theCompany’s 2000 Employee Stock Purchase Plan (the “ESPP”) during the threemonths ended January 31, 2005 and 2004, the assumptions used in theBlack-Scholes option-pricing model are as follows:

 
| ** **                        | ** ** | **Three Months Ended January 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                        | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Risk-free interest rate           |       | 3.4                                     | %          | 2.4 | % |
| Expected dividend yield           |       | 0.0                                     | %          | 0.0 | % |
| Volatility                        |       | 88.6                                    | %          | 73.4 | % |
| Expected exercise life (in years) |       | 2.7                                     |       | 3.1 |   |

 

For purposes of the pro formadisclosure, the estimated fair value of stock options, restricted stock awardsand ESPP shares are amortized over the vesting period of the award.  The following is the pro forma disclosure andthe related impact on net loss to common stockholders and the net loss tocommon stockholders per diluted common share for the three months ended January 31,2005 and 2004 (in thousands, except per share amounts):

 
| ** **                                                                      | ** ** | **Three Months Ended January 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Net loss applicable to common stockholders:                                     |       |                                    |       |   |   |
| As reported                                                                     |       | $                                       | (2,961     | ) | $ | (2,486 | ) |
| Stock-based compensation included in reported net  loss                         |       | 15                                      |       | 435 |   |
| Stock-based compensation under fair value method                                |       | (194                                    | )          | (807 | ) |
| Pro forma net loss applicable to common stockholders                            |       | $                                       | (3,140     | ) | $ | (2,858 | ) |
|                                                                            |       |                                    |       |   |   |
| Net loss applicable to common stockholders per basic  and diluted common share: |       |                                    |       |   |   |
| As reported                                                                     |       | $                                       | (0.17      | ) | $ | (0.18 | ) |
| Pro forma                                                                       |       | $                                       | (0.18      | ) | $ | (0.21 | ) |

 

8

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In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial AccountingStandards No. 123R, “Share-Based Payment, an amendment ofFASB Statements Nos. 123 and 95,” which requires the measurement ofall employee share-based payments to employees, including grants of employeestock options, using a fair-value-based method and the recording of suchexpense in the Consolidated Statements of Operations and ComprehensiveLoss.  The accounting provisions ofSFAS No. 123R are effective for reporting periods beginning after June 15,2005 and the Company will adopt SFAS No. 123R in the fourth quarterof fiscal year 2005.  The abovedisclosure for the three months ended January 31, 2005 and 2004 shows thepro forma net loss and net loss per share as if the Company had used afair-value-based method similar to the methods required under SFAS No. 123Rto measure compensation expense for employee stock incentive awards.  Although the Company has not yet determinedwhether the adoption of SFAS No. 123R will result in future amountsthat are similar to the current pro forma disclosure under SFAS No. 123,the Company is evaluating the requirements under SFAS No. 123R andexpects that the adoption could have a material impact on the Company’s netincome (loss).

 

**Cash and Cash Equivalents**

 

The Company considers all investments purchased withoriginal maturities of three or fewer months to be cash equivalents.  Cash equivalents were $4,048,000 and$2,633,000 as of January 31, 2005 and October 31, 2004,respectively.  Cash was $5,438,000 and$10,060,000 as of January 31, 2005 and October 31, 2004,respectively.

 

**Available-for-Sale Securities**

 

Available-for-sale securities are recorded at fairmarket value, based on quoted market prices, and unrealized gains and lossesare recorded as a component of comprehensive income (loss).  Realized gains and losses, which arecalculated based on the specific-identification method, are recorded inoperations as incurred.

 

Available-for-sale securities totaled $5,946,000 as ofJanuary 31, 2005 and consisted of government agency securities andcorporate notes.  Any available-for-salesecurities in an unrealized loss position as of January 31, 2005 were notimpaired at acquisition and the decline in fair value is primarily attributableto interest rate fluctuations.  A declinein the market value of any available-for-sale security below cost that is deemedother than temporary results in a charge to earnings and establishes a newbasis for the security.

 

**Earnings per Share**

 

Basic net income (loss) per common share (“Basic EPS”)is computed by dividing net income (loss) by the weighted average number ofcommon shares outstanding.  Diluted netincome (loss) per common share (“Diluted EPS”) is computed by dividing netincome (loss) by the sum of the weighted average number of common sharesoutstanding and the dilutive potential common share equivalents thenoutstanding.  Potential common share equivalentsconsist of the weighted average of shares issuable upon the exercise ofoutstanding stock options, restricted stock awards, warrants to acquire commonstock and preferred stock convertible into common shares.  If dilutive, the Company computes Diluted EPSusing the treasury stock method.

 

9

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The following table is a reconciliation of thenumerator and denominator of Basic EPS to the numerator and denominator ofDiluted EPS for the three months ended January 31, 2005 and 2004 (inthousands, except per share amounts):

 
| ** **                                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
|                                               |       |     |       |     |       |
| Numerator:                                         |       |     |       |     |       |
| Net loss applicable to common stockholders         |       | $        | (2,961     | )        | $          | (2,486 | ) |
| Denominator:                                       |       |     |       |     |       |
| Weighted average common shares outstanding         |       | 17,751   |       | 13,824   |       |
| Stock options                                      |       | —   |       | —   |       |
| Restricted stock                                   |       | —   |       | —   |       |
| Warrants                                           |       | —   |       | —   |       |
| Weighted average diluted common shares outstanding |       | 17,751   |       | 13,824   |       |
| Basic and diluted EPS                              |       | $        | (0.17      | )        | $          | (0.18 | ) |
|                                               |       |     |       |     |       |
| Excluded anti-dilutive common share equivalents    |       | 3,784    |       | 6,548    |       |

 

The excluded anti-dilutive common share equivalentsare not included in the computation of Diluted EPS as their effect isanti-dilutive to the loss per share.

 

**Income Taxes**

 

In October 2004, the American Jobs Creation Act(the “AJCA”) was signed into law.  TheAJCA includes a deduction of 85 percent of certain foreign earnings that arerepatriated in the AJCA.  The Company mayelect to apply this provision to qualifying earnings repatriations in fiscalyear 2005.  The Company does not believethat it will have any foreign earnings repatriation under the AJCA duringfiscal year 2005.

 

**Reclassifications**

 

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

 

**(3) INTANGIBLE ASSETS**

 

The following table shows the activity related toamortized intangible assets for the three months ended January 31, 2005 aswell as the remaining unamortized balances as of January 31, 2005 (inthousands):

 
| ** **                     | ** ** | **As of  October 31, 2004** | ** ** | **Three Months Ended  January 31, 2005** | ** ** | **As of  January 31, 2005** | ** ** |
|--------------------------------|------------|----------------------------------|------------|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **Net Book Value**               | ** ** | **Amortization  Expense**                     | ** ** | **Impairment  Loss**             | ** ** | **Net Book Value** | ** ** |
| Amortizable intangible assets: |       |                             |       |                                          |       |                             |       |   |   |
| Distribution/reseller channel  |       | $                                | 4,636      |                                          | $          | (579                             | )          | $ | — |   | $ | 4,057 |   |
| Acquired technology            |       | 673                              |       | (84                                           | )          | —                           |       | 589 |   |
| Trade name                     |       | 104                              |       | (13                                           | )          | —                           |       | 91 |   |
| Total intangible assets        |       | $                                | 5,413      |                                          | $          | (676                             | )          | $ | — |   | $ | 4,737 |   |

 

10

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Of the $676,000 in amortization expense, $593,000 wasclassified as amortization of intangible assets in operating expenses and theremaining $83,000 was classified as cost of SCOsource licensing revenue.

 

**(4) COMMITMENTS AND CONTINGENCIES**

 

**Litigation**

 

The following includesupdated information relating to certain of the Company’s material legalproceedings as previously reported in the Company’s Annual Report on Form 10-Kfor fiscal year 2004.

 

*IBM Corporation*

 

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

 

Following a hearing on October 19,2004, on January 19, 2005, the United States Magistrate Judge overseeingthe case issued an order granting in part and denying in part discoveryapplications that the Company had made. The Court ordered IBM to produce much of the information, includingsource code, revision information, and programmer contribution information,that the Company had previously requested. The court also struck the Amended Scheduling Order and directed theparties to submit a proposed amended scheduling order to the court, which bothparties have done.

 

In response to theMagistrate Court’s Order, IBM filed, on February 11, 2005, a Motion forReconsideration of the portion of the Order that required IBM to produceprogrammer-contribution information for 3,000 people.  The parties have fully briefed this motion,but no date has been set for oral arguments.

 

IBM also filed, on March 9,2005,  a Motion for a 45-dayExtension of Time to Comply with the Court’s January 18 Order as itapplies to materials that are not the subject of IBM’s above-referenced Motionfor Reconsideration.  On March 16,2005, the Court granted the extension and entered an order requiring IBM toproduce those materials by May 3, 2005. With respect to the materials that are the subject of IBM’s Motion forReconsideration, the Court granted IBM’s request to stay its discoveryobligations until the Court rules on that motion.

 

On February 9, 2005,the United States District Judge ruled on several pending dispositivemotions.  The Court denied the threemotions for partial summary judgment that IBM had filed on the Company’scontract claims, on IBM’s eighth counterclaim for copyright infringement, andon IBM’s tenth counterclaim for a declaration of non-infringement of theCompany’s copyrights.  The Court deniedeach of those motions without prejudice to IBM’s renewing or refiling themotions after discovery is complete.  TheCourt also denied the Company’s motion to stay or dismiss IBM’s tenthcounterclaim.  The Court ordered that nofurther dispositive motions could be filed until the close of discovery, exceptby stipulation of the parties, and vacated its prior order, dated September 30,2004, to the extent that order had granted permission to file dispositivemotions before the close of discovery.

 

11

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Additional discoverymotions that the Company has filed are also pending before the Court.  On January 12, 2005, the Company filedits Motion to Compel IBM to produce IBM CEO Samuel J. Palmisano forDeposition.  The parties have fullybriefed this motion, and the Court has scheduled oral arguments for April 21,2005.  The parties have also now fullybriefed the Company’s December 23, 2004 Renewed Motion to CompelDiscovery, which seeks to compel IBM’s compliance with prior Court ordersrelating to IBM’s obligation to produce (1) all documents pertaining toLinux from the files of high-level IBM executives and board members; and (2) tocompel IBM to produce witnesses to testify on several topics in two depositionnotices that SCO has served on IBM.  TheCourt has not set a hearing date for this motion.

 

In addition to thematerials that have been publicly filed with the Court, certain information hasbeen filed under seal in accordance with the protective order entered in thecase.  On November 30, 2004, a thirdparty moved to intervene in the case for the purpose of challenging the sealingof certain documents filed with the Court. Additional groups have joined in that motion, which has been scheduledfor a hearing on April 26, 2005.

 

The Company has alsofiled a motion for leave to file a third amended complaint in order to assertan additional copyright claim against IBM in the case.  Argument on that motion has been scheduledfor April 21, 2005, but the Company has requested that the Court adjournthat argument date to permit the Company to amend its complaint further bypotentially adding additional claims against IBM.  IBM has filed an opposition to the Company’smotion to adjourn the April 21 hearing. The Company currently anticipates it will assert those new claims in thenear future.

 

In support of its pendingmotion to amend, the Company argued that IBM would not be prejudiced by theproposed amendment because, among other things, the Company’s new claimpertained to issues already covered by IBM’s own Ninth Counterclaim, whichseeks a broad declaratory judgment of non-infringement relating to AIX.  On February 18, 2005, IBM filed a Motionfor Entry of Order Limiting the Scope of Its Ninth Counterclaim.  That motion has also been briefed, but noargument date has been set.

 

Discovery is continuing in the case.

 

*Red Hat, Inc.*

 

On August 4, 2003, Red Hat, Inc. (“Red Hat”)filed a complaint against the Company. The action is pending in the United States District Court for theDistrict of Delaware under the case caption Red Hat, Inc. v. The SCO Group, Inc.,Civil No. 03-772.  Red Hatasserts that the Linux operating system does not infringe on the Company’s UNIXintellectual property rights and seeks a declaratory judgment fornon-infringement of copyrights and no misappropriation of trade secrets.  In addition, Red Hat claims the Company hasengaged in false advertising in violation of the Lanham Act, deceptive tradepractices, unfair competition, tortious interference with prospective businessopportunities, trade libel and disparagement. On April 6, 2004, the court denied the Company’s motion to dismissthis case; however, the court stayed the case and requested status reportsevery 90 days regarding the case against IBM. Red Hat filed a motion for reconsideration, which the Court denied on March 31,2005.  The Company intends to vigorouslydefend this action.

 

*Novell, Inc.*

 

On January 20, 2004, the Company filed suitin Utah state court against Novell, Inc. (“Novell”) for slander of titleseeking relief for its alleged bad faith effort to interfere with the Company’sownership of copyrights related to its UNIX source code and derivative worksand its UnixWare product.  The case,after removal to federal court, is pending in the United Stated District Courtfor the District of Utah under the caption The SCO Group, Inc. v. Novell, Inc.,Civil No. 2:04CV00139.

 

12

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In the lawsuit, the Company requested preliminary andpermanent injunctive relief as well as damages. Through these claims, the Company seeks to require Novell to assign tothe Company all copyrights that it believes Novell has wrongfully registered,prevent Novell from representing any ownership interest in those copyrights andrequire Novell to retract or withdraw all representations it has made regardingits purported ownership of those copyrights.

 

Novell has filed a motion to dismiss claiming, amongother things, that Novell’s false statements were not uttered with malice andare privileged under the law.  Thatmotion has been briefed by the parties and is scheduled to be argued to thecourt on May 25, 2005.  The Companyintends to continue to vigorously pursue its claims against Novell.

 

*DaimlerChrysler Corporation*

 

On or about March 3, 2004, the Company broughtsuit against DaimlerChrysler Corporation (“DaimlerChrysler”) for its allegedviolations of its UNIX license agreement with the Company.  The lawsuit alleges that DaimlerChryslerbreached its UNIX software agreement by failing to provide an adequate ortimely certification of its compliance with that agreement as the Companyrequested.  The lawsuit, filed in OaklandCounty Circuit Court in the State of Michigan, requests the court to declarethat 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 the Company damages in an amount to be determinedat trial together with costs, attorneys’ fees and any such other or differentrelief that the court may deem to be equitable and just.

 

In response to DaimlerChrysler’s motion to dismiss,the court granted DaimlerChrysler’s motion as to the substance ofDaimlerChrysler’s certification, but denied the motion as to whether thecertification was timely.  Based on thisruling, the Company filed a motion to stay the case pending the clarificationof certain issues in the IBM litigation. The court denied the motion to stay. Based on a stipulation of the parties, however, the court signed anorder of dismissal without prejudice. The appellate court has dismissed the Company’s appeal of the July 21,2004 ruling finding that the order was not a final, appealable order; theCompany is evaluating its options regarding the appellate court’s ruling.

 

*AutoZone, Inc.*

 

On or about March 2, 2004, the Company broughtsuit against AutoZone, Inc. (“AutoZone”) for its alleged violations of theCompany’s UNIX copyrights through its use of Linux.  The lawsuit alleges copyright infringement byAutoZone by, among other things, running versions of the Linux operating systemthat contain proprietary material from UNIX System V.  The lawsuit, filed in United States DistrictCourt in Nevada, requests injunctive relief against AutoZone’s further use orcopying of any part of the Company’s copyrighted materials and also requestsdamages as a result of AutoZone’s infringement in an amount to be proven attrial.  In response to AutoZone’s motionto transfer the case to Tennessee or stay the case, the federal court in Nevadagranted AutoZone’s motion to stay the case, with 90-day status reports tothe court, and denied without prejudice AutoZone’s motion to transfer the caseto Tennessee.  The court is allowing theparties to take limited expedited discovery relating to the issue ofpreliminary injunctive relief.  TheCompany is currently pursuing that discovery and continuing to evaluate itsclaims in that regard.

 

*IPO Class Action Matter*

 

The Company is an issuerdefendant in a series of class action lawsuits involving over 300 issuers thathave been consolidated under In re Initial Public Offering SecuritiesLitigation, 21 MC 92 (SAS).  Theconsolidated complaint alleges, among other things, certain improprieties

 

13

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regarding the underwriters’ conduct during the Company’sinitial public offering and the failure to disclose such conduct in theregistration statement in violation of the Securities Act of 1933, as amended.

 

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

 

The Company has notifiedits underwriters and insurance companies of the existence of the claims.  Management believes, after consultation withlegal counsel, that the ultimate outcome of this matter will not have amaterial adverse effect on the Company’s results of operations or financialposition and will not exceed the $200,000 self-insured retention already paidor accrued by the Company.

 

*Other Matters*

 

In April 2003, aformer Indian distributor of the Company filed a claim in India, requestingsummary judgment for payment of $1,428,000, and an order that the Company tradein India only through the distributor and/or give a security deposit until theclaim is paid.  The distributor claimsthat the Company is responsible to repurchase certain software products and toreimburse the distributor for certain other operating costs.  The distributor additionally requested thatthe Indian courts grant interim relief in the form of attachment of localassets.  Management does not believe thatthe Company is responsible to reimburse the distributor for any operating costsand also believes that the return rights related to any remaining inventoryhave lapsed.  Discovery has commenced andhearings on the requests for interim relief have been held and areongoing.  The Company intends tovigorously defend this action.

 

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

 

The Company is a party tocertain other legal proceedings arising in the ordinary course ofbusiness.  Management believes, afterconsultation with legal counsel, that the ultimate outcome of such legalproceedings will not have a material adverse effect on the Company’s results ofoperations or financial position.

 

**Grants of Unregistered Stock Options; PotentialInterest and Penalties Related to Rescission Rights**

 

The Company believes certain shares and optionsgranted under its 1998 Stock Option Plan, 1999 Omnibus Stock Option Plan, theESPP, 2002 Omnibus Stock Incentive Plan, and 2004 Omnibus Stock Incentive Plan(collectively, the “Equity Compensation Plans”) were issued without complyingwith registration or qualification requirements under federal securities lawsand the securities laws of certain states. As a result, certain plan participants have a right to rescind theirpurchases of shares under the Equity Compensation Plans or recover damages ifthey 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.

 

14

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The Company believes certain of its stock optiongrants made since February 2003 may have also violated applicablesecurities laws in California, Georgia and possibly other states even thoughholders have not exercised such options. Although the Company is continuing to evaluate its potential rescissionrisk to option holders, the Company is considering making a rescission offer tocertain option holders.  Because theoptions in question have not been exercised, no amounts are recorded inpermanent equity.  There are a number offactors that must be considered in determining what a rescission offer tooption holders may involve.  At thecurrent time, the Company is unable to determine and quantify all of the keyfactors for a potential rescission offer.

 

The Company believes that it is reasonably possiblethat some option holders may accept a rescission offer, but the Company isunable to estimate the number of participants who might accept a rescissionoffer and the amount of potential damages that it would be required to payunder a rescission offer.  Since any lossis considered reasonably possible but not estimable, the Company has notrecorded a liability for this contingency.

 

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

 

**(5) COMMONSTOCK SUBJECT TO RESCISSION**

 

As described in Note 4, certain participants in theEquity Compensation Plans 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.

 

Accounting Series Release (“ASR”) No. 268 andEmerging Issues Task Force (“EITF”) Topic D-98 require that stock subjectto rescission or redemption requirements outside the control of the Company tobe classified outside of permanent equity. The exercise of the rescissionright is at the holders’ discretion, but exercise of that right may depend inpart on the fair value of the Company’s common stock, which is outside of theCompany’s and the holders’ control. Consequently, common stock subject to rescission is classified astemporary equity.  If the Company’spossible rescission offer is made and accepted by plan participants holdingshares acquired under the Equity Compensation 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 required to make aggregate payments to these planparticipants of up to $893,000 in the aggregate, excluding interest and otherpossible fees, based upon shares outstanding under the Equity CompensationPlans as of January 31, 2005.

 

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

 

**(6) STOCKHOLDERS’ EQUITY**

 

**Stock Options**

 

During the three months ended January 31, 2005,the Company granted options to purchase 631,000 shares of common stock with anaverage exercise price of $4.71 per share. None of these stock options were granted with an exercise price belowthe quoted market price on the

 

15

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date of grant. During the three months ended January 31, 2005, options to purchaseapproximately 135,000 shares of common stock were exercised with an averageexercise price of $1.47 per share.  As ofJanuary 31, 2005, there were approximately 3,524,000 stock optionsoutstanding with a weighted average exercise price of $4.32 per share.

 

**Change in Control Agreements**

 

On December 10, 2004, the Company entered in Change inControl Agreements with the following executive officers:  Darl C. McBride; Bert B. Young; ChristopherSontag; Jeff F. Hunsaker; and Ryan E. Tibbitts (each, an “Officer”).  Each agreement is effective as of December 10,2004.

 

Pursuant to the terms of eachAgreement, the Officer agrees that he or she will not voluntarily leave theemploy of the Company in the event any individual, corporation, partnership,company or other entity takes certain steps to effect a Change in Control (asdefined in the Agreement) of the Company, until the attempt to effect a Changein Control has terminated, or until a Change in Control occurs.

 

If the Officer is still employed by theCompany when a Change in Control occurs, any stock, stock option or restrictedstock granted to the Officer by the Company that would have become vested uponcontinued employment by the Officer shall immediately vest in full and becomeexercisable notwithstanding any provision to the contrary of such grant andshall remain exercisable until it expires or terminates in accordance with itsterms.  Each Officer shall be solelyresponsible for any taxes that arise or become due pursuant to the accelerationof vesting that occurs pursuant to the Agreement.

 

The adoption of the Change in ControlAgreements allows for accelerated vesting on all outstanding shares of commonstock and represents a modification to the underlying stock option award.  In accordance with Financial AccountingStandards Board (“FASB”) Interpretation No. 44 “Accounting for CertainTransactions Involving Stock Compensation,” the Company has calculated thetotal intrinsic value of the awards of $2,012,000 which represents the value ofthe awards that were subject to the acceleration.  During the three months ended January 31,2005, this amount had not been recorded in the condensed consolidated financialstatements as an event to trigger the acceleration was not considered probable.

 

**Stockholder Rights Plan**

 

On August 10, 2004, theCompany’s Board of Directors adopted a Stockholder Rights Plan (the “RightsPlan”) designed to deter coercive takeover tactics, including accumulation ofshares in the open market or through private transactions and to prevent anacquirer from gaining control of the Company without offering a fair price toall of the Company’s stockholders.

 

Under theterms of the Rights Plan, Series A Junior Participating Preferred Stockpurchase rights will be distributed as a dividend at the rate of one right foreach share of common stock of the Company held by stockholders of record as ofthe close of business on August 30, 2004. The Rights Plan would be triggered if a person or group acquiredbeneficial ownership of 15 percent or more of the Company’s common stock otherthan pursuant to a board-approved tender or exchange offer or commences, orpublicly announces an intention to commence, a tender or exchange offer uponconsummation of which such person or group would beneficially own 15 percent ormore of the Company’s common stock.  Thevalue of the purchase rights is immaterial as of January 31, 2005.

 

16

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**(7) CONCENTRATIONOF RISK**

 

As of January 31, 2005 and October 31, 2004,the Company had no customers who made up more than 10 percent of the endingaccounts receivable balance.

 

During the three months ended January 31, 2005,no single customer accounted for more than 10 percent of total revenue.  During the three months ended January 31,2004, one customer accounted for approximately 10 percent of total revenue.

 

**(8) RELATED PARTY TRANSACTIONS**

 

As of January 31, 2005, The Canopy Group, Inc.(“Canopy”) owned approximately 31 percent of the Company’s issued andoutstanding common stock.  As describedin more detail in Note 10, Canopy transferred all of its shares of common stockeffective March 11, 2005.

 

On April 30, 2003, the Company and Center 7, Inc.(“C7”) entered into a Marketing and Distribution Master Agreement (the “MarketingAgreement”) and an Assignment Agreement. On October 2, 2003, C7 assigned the Assignment Agreement to Vintela, Inc.(“Vintela”) and Vintela and the Company entered into a new marketing agreement(the “Vintela Agreement”).  Both C7 andVintela are majority owned by Canopy. Under the Vintela Agreement, the Company was appointed as a worldwidedistributor for Vintela products to co-brand, market and distribute theseproducts.

 

Under the Assignment Agreement, the Company assignedthe copyright applications, patents and contracts related to Volution Manager,Volution Authentication, Volution Online and Volution Manager Update Service(collectively, the “Assigned Software”). As consideration for this assignment, C7 issued and Vintela assumed, a$500,000 non-recourse promissory note payable to the Company, secured by theAssigned Software.  This note wasoriginally due on April 30, 2005 with interest payable at a rate of onepercent above the prime rate as reported in the Wall Street Journal.

 

In late November 2004, the Company entered intodiscussions with Vintela with respect to the cancellation of the Marketing Agreementand repayment of the Note.  It was laterdetermined and decided once Vintela had received funding from an outside thirdparty, the Company agreed with Vintela to forego any interest charges on thepromissory note in return for an immediate payment of the $500,000.  On December 9, 2004, the Companyreceived the $500,000 payment from Vintela and forgave the outstanding interestcharges associated with the promissory note.

 

At the time the promissory note was executed, theCompany had no recorded basis in the Assigned Software.  Because the transfer of the Assigned Softwarewas to a related party in exchange for a promissory note and there wassubstantial doubt concerning the ability of C7 to repay the debt as they werenot profitable and being funded by Canopy, no gain was recognized by theCompany until payment was received on December 9, 2004.  The Company recorded the $500,000 received asa component of other income in its statement of operations for the three monthsended January 31, 2005.

 

**(9) SEGMENT INFORMATION**

 

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

 

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During fiscal year 2004, in an effort to maximize theassets and resources of the UNIX and SCOsource business segments and to bestrepresent management’s view of business operations, the Company directedresources and reviewed financial information for its UNIX and SCOsourcesegments.  Segment disclosures for theCompany are as follows (in thousands):

 
| ** **                    | ** ** | **Three Months Ended January 31,  2005** | ** ** |
|-------------------------------|------------|-----------------------------------------------|------------|
| ** **                    | ** ** | **UNIX**                                      | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                          |       |                                          |       |   |   |   |   |
| Revenue                       |       | $                                             | 8,795      |   | $ | 70 |   | $ | 8,865 |   |
| Cost of revenue               |       | 1,393                                         |       | 3,493 |   | 4,886 |   |
| Gross margin (deficit)        |       | 7,402                                         |       | (3,423 | ) | 3,979 |   |
| Sales and marketing           |       | 2,790                                         |       | 147 |   | 2,937 |   |
| Research and development      |       | 1,968                                         |       | 112 |   | 2,080 |   |
| General and administrative    |       | 1,672                                         |       | 91 |   | 1,763 |   |
| Other                         |       | 608                                           |       | — |   | 608 |   |
| Total operating expenses      |       | 7,038                                         |       | 350 |   | 7,388 |   |
| Income (loss) from operations |       | $                                             | 364        |   | $ | (3,773 | ) | $ | (3,409 | ) |

 
| ** **                 | ** ** | **Three Months Ended January 31,  2004** | ** ** |
|----------------------------|------------|-----------------------------------------------|------------|
| ** **                 | ** ** | **UNIX**                                      | ** ** | **SCOsource** | ** ** | **Total** | ** ** |
|                       |       |                                          |       |   |   |   |   |
| Revenue                    |       | $                                             | 11,372     |   | $ | 20 |   | $ | 11,392 |   |
| Cost of revenue            |       | 2,127                                         |       | 3,523 |   | 5,650 |   |
| Gross margin               |       | 9,245                                         |       | (3,503 | ) | 5,742 |   |
| Sales and marketing        |       | 5,011                                         |       | 10 |   | 5,021 |   |
| Research and development   |       | 2,680                                         |       | 27 |   | 2,707 |   |
| General and administrative |       | 2,172                                         |       | 22 |   | 2,194 |   |
| Other                      |       | 1,222                                         |       | — |   | 1,222 |   |
| Total operating expenses   |       | 11,085                                        |       | 59 |   | 11,144 |   |
| Loss from operations       |       | $                                             | (1,840     | ) | $ | (3,562 | ) | $ | (5,402 | ) |

 

Intangible assets, which consist of the Company’sreseller channel, trade name and technology, have been assigned to the Company’sUNIX and SCOsource segments and consist of the following as of January 31,2005 and October 31, 2004 (in thousands):

 
| ** **                             | ** ** | **January 31,  2005** | ** ** | **October 31,  2004** | ** ** |
|----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Intangible assets:                     |       |                       |       |                       |       |
| UNIX (reseller channel and trade name) |       | $                          | 4,148      |                       | $          | 4,740 |   |
| SCOsource (UNIX technology)            |       | 589                        |       | 673                        |       |
| Total intangible assets and goodwill   |       | $                          | 4,737      |                       | $          | 5,413 |   |

 

**(10) SUBSEQUENT EVENTS**

 

**Transfer of Stock Ownership by Canopyto Ralph J. Yarro III**

 

Effective March 11, 2005, Canopy transferred allof its shares of the Company’s common stock to Ralph J. Yarro III, the Chairmanof the Company’s Board of Directors.

 

18

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**Sale of Troll Tech Shares**

 

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

 

During the second quarter of fiscal year 2005, theCompany received notice from Troll Tech that a third party investor wasinterested in acquiring the Company’s shares of Troll Tech.  On March 14, 2005, the Company receivedproceeds of $779,100 for the Troll Tech shares. The Company will account for the sale and proceeds of the Troll Techshares in the second quarter of fiscal year 2005 when it received the proceedsfrom the shares.  All amounts related tothe book value of the shares had been written off during fiscal year 2001, andthe Company expects to record the proceeds received as a component of otherincome in its statements of operations for the three and six months ended April 30,2005.

 

19

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| **ITEM  2.** | ** ** | **MANAGEMENT’S DISCUSSION 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 Form 10-Q contain forward-looking statements that involverisks and uncertainties.  Forward-lookingstatements can also be identified by words such as “intends,” “anticipates,” “expects,”“believes,” “plans,” “predicts,” and similar terms.  Forward-looking statements are not guaranteesof future performance and our actual results may differ significantly from theresults discussed in the forward-looking statements.  Factors that might cause such differencesinclude, but are not limited to, those set forth below under “Forward-LookingStatements” and “Risk Factors” and elsewhere in this Form 10-Q. Thefollowing discussion should be read in conjunction with our consolidatedfinancial statements and notes thereto included in this Form 10-Qand our annual report on Form 10-K for the year ended October 31,2004 filed with the Securities and Exchange Commission, including the auditedfinancial statements and management’s discussion and analysis containedtherein.  All information presentedherein is based on the three months ended January 31, 2005.  We assume no obligation to revise or updateany forward-looking statements for any reason, except as required by law.*

 

**Overview**

 

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

 

*Recent Developments.*** **As described elsewhere in this Form 10-Q, we issued shares and granted optionsunder our 1998 Stock Option Plan, 1999 Omnibus Stock Option Plan, the 2000Employee Stock Purchase Program (the “ESPP”), 2002 Omnibus Stock IncentivePlan, and 2004 Omnibus Stock Incentive Plan (collectively, the “Equity Compensation Plans”) 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 Equity Compensation Plansor recover damages if they no longer own the shares or hold unexercisedoptions, subject to applicable statutes of limitations.  Although we are evaluating the possibleactions we may take in response to these securities law compliance issues, wemay make a rescission offer to certain plan participants entitled to rescissionrights subject to obtaining required regulatory approvals.  If our potential rescission offer is made andaccepted by all plan participants holding certain ESPP shares and all sharesacquired from the exercise of stock options, or such participants otherwisemake rescission claims against us, we could be required to make aggregatepayments to these plan participants of up to $893,000.  This amount is based on  shares issued pursuant to the ESPP and sharesissued upon the exercise of stock options that have been retained by planparticipants as of January 31, 2005 and excludes interest and othercharges we may be required to pay.  Wemay face additional rescission liability to plan participants holdingunexercised stock options in California, Georgia and possibly other states, andregulatory authorities also may require us to pay fines or impose othersanctions on us.

 

20

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On February 16, 2005, we received a notice fromthe staff of The Nasdaq Stock Market indicating that we are subject topotential delisting from The Nasdaq SmallCap Market for failure to comply withNasdaq’s requirement to file our Form 10-K for the fiscal year endedOctober 31, 2004 in a timely fashion. Receipt of the notice did not result in immediate delisting of ourcommon stock.  Nasdaq stated that, unlesswe requested a hearing on Nasdaq’s delisting notice, our securities would bedelisted from The Nasdaq SmallCap Market at the opening of business on February 25,2005.

 

We requested a hearing with the Nasdaq ListingQualifications Panel on this matter, which stayed the delisting pending thehearing and a determination by the Nasdaq Listing Qualifications Panel.  The hearing occurred on March 17,2005.  At the hearing, we outlined forthe Panel our plan for filing our Form 10-K and this Form 10-Q,which also was not filed in a timely fashion. On March 18, 2005, we received another notice from the staff of TheNasdaq Stock Market regarding our potential delisting as a result of ourfailure to file this Form 10-Q in a timely fashion.  The notice informed us that the Panel willconsider the filing delinquency of our Form 10-Q in addition to thefiling delinquency of the Form 10-K in rendering its decisionregarding our listing status.  On April 1,2005, we filed our Form 10-K, and this Form 10-Q wasfiled on April 14, 2005.  We willcontinue to be listed on The Nasdaq SmallCap Market under the symbol SCOXEpending the issuance of the Panel’s decision.

 

In connection with our determination that certain planparticipants have a right to rescind their purchases of shares under the EquityCompensation Plans or recover damages if they no longer own the shares or holdunexercised options, we determined we needed to classify our common stock thatis subject to rescission as temporary equity. As a result, on April 1, 2005, we filed amended Form 10-Qsfor the quarters ended January 31, 2004, April 30, 2004 and July 31,2004 with restated condensed consolidated financial statements.  In the restated financial statements for eachof the periods covered by the amended Form 10-Qs, we reclassifiedour common stock subject to rescission from permanent equity to temporaryequity and made certain other changes as described in Note 2 to the financialstatements in each of the amended Form 10-Qs.  The restatement of these financial statementsdid not impact our previously reported revenue, net loss or its earnings pershare for the fiscal year ended October 31, 2004 or our aggregate cash andavailable for sale securities balances as of October 31, 2004.

 

**Business Focus**

 

We generate revenue fromsales of product and services from our UNIX business and from sales ofSCOsource intellectual property (“IP”) licenses and vendor licenses from ourSCOsource business.

 

*UNIX Business. *Our UNIXbusiness serves the needs of small-to-medium sized businesses, includingreplicated site franchisees of Fortune 1000 companies, by providing reliable,cost effective UNIX operating systems and software products to power computersrunning on Intel architecture.  Ourlargest source of UNIX business revenue is derived from existing customersthrough our worldwide, indirect, leveraged channel of partners which includesdistributors and independent solution providers.  We have a presence in a number of countriesthat provide support and services to customers and resellers.  The other principal channel for selling andmarketing our UNIX products is through existing customers that have a large numberof replicated sites or franchisees.

 

We access these corporationsthrough their information technology or purchasing departments with our ASMs inthe United States and through our reseller channel in countries outside theUnited States.  In addition, we also sellour operating system products to original equipment manufacturers (“OEMs”).  Our sales of UNIX products and servicesduring the last several fiscal years have been primarily to pre-existing UNIXcustomers and not newly acquired

 

21

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customers.  Our UNIX business revenue dependssignificantly on our ability to market and sell our products to existingcustomers and to generate upgrades from existing customers.

 

The following table shows theoperating results of the UNIX business for the three months ended January 31,2005 and 2004 (in thousands):

 
| ** **                    | ** ** | **Three Months Ended January 31,** | ** ** |
|-------------------------------|------------|-----------------------------------------|------------|
| ** **                    | ** ** | **2005**                                | ** ** | **2004** | ** ** |
|                          |       |                                    |       |   |   |
| Revenue                       |       | $                                       | 8,795      |   | $ | 11,372 |   |
| Cost of revenue               |       | 1,393                                   |       | 2,127 |   |
| Gross margin                  |       | 7,402                                   |       | 9,245 |   |
| Sales and marketing           |       | 2,790                                   |       | 5,011 |   |
| Research and development      |       | 1,968                                   |       | 2,680 |   |
| General and administrative    |       | 1,672                                   |       | 2,172 |   |
| Other                         |       | 608                                     |       | 1,222 |   |
| Total operating expenses      |       | 7,038                                   |       | 11,085 |   |
| Income (loss) from operations |       | $                                       | 364        |   | $ | (1,840 | ) |

 

Revenue from our UNIXbusiness decreased by $2,577,000, or 23 percent, for the first quarter offiscal year 2005 compared to the first quarter of fiscal year 2004.  The revenue from this business has beendeclining over the last several quarters primarily as a result of increasedcompetition from alternative operating systems, particularly Linux.  If revenue from our UNIX businesscontinues to decline and we are unable to generate positive cash flow, our UNIXbusiness will be adversely impacted.

 

In an effort to try to reachprofitability in our UNIX business, we have decreased our operating costs andincreased our gross margin percentage. Operating costs for our UNIX business decreased from $11,085,000 for thefirst quarter of fiscal year 2004 to $7,038,000 for the first quarter of fiscalyear 2005.  These cost reductions haveprimarily been attributable to reduced headcount and continued operationalefficiencies generated in our UNIX business as well as from the consolidationof certain facilities.

 

In our UNIX business, we havereduced the number of full-time equivalent employees from 292 as of January 31,2004, to 165 as of January 31, 2005. We have taken these headcount reductions and reduced other discretionaryspending while still maintaining a worldwide presence.  Based on our cost-cutting actions, weanticipate that our UNIX business will continue to generate positive cash flowthroughout fiscal year 2005.

 

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

 

An important initiative forour UNIX business for the 2005 fiscal year will be the release of the SCOOpenServer 6 operating system in the first half of calendar year 2005.  This new version will provide increased systemreliability, backward compatibility with existing applications and software,increased application and hardware support, integration with widely usedinternet applications and increased system performance.  These enhancements will not have a directimpact on our short-term OpenServer revenue because of the long adoption cyclefor new operating system purchases and our long operating system product salescycle, but we believe that they will help prolong our OpenServer revenue streamfor future quarters.

 

22

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

 

In an effort to protect ourUNIX intellectual property, we initiated our SCOsource business.  These initiatives now include seeking toenter into license agreements with UNIX vendors and offering SCOsource IPlicenses to Linux and other end users allowing them to continue to use our UNIXsource code and derivative works found in Linux.  We believe that our SCOsource licensing revenueopportunities have been adversely impacted by our outstanding dispute withNovell over our UNIX copyright ownership, which may have caused many potentialcustomers to delay or forego licensing until an outcome in this legal matterhas been reached.

 

During fiscal year 2004, we began assigning directresources to the SCOsource business for sales and marketing, research anddevelopment and general and administrative.* *The following table shows the operatingresults of the SCOsource business for the three months ended January 31,2005 and 2004 (in thousands):

 
| ** **                 | ** ** | **Three Months Ended January 31,** | ** ** |
|----------------------------|------------|-----------------------------------------|------------|
| ** **                 | ** ** | **2005**                                | ** ** | **2004** | ** ** |
|                       |       |                                    |       |   |   |
| Revenue                    |       | $                                       | 70         |   | $ | 20 |   |
| Cost of revenue            |       | 3,493                                   |       | 3,523 |   |
| Gross deficit              |       | (3,423                                  | )          | (3,503 | ) |
| Sales and marketing        |       | 147                                     |       | 10 |   |
| Research and development   |       | 112                                     |       | 27 |   |
| General and administrative |       | 91                                      |       | 22 |   |
| Other                      |       | —                                  |       | — |   |
| Total operating expenses   |       | 350                                     |       | 59 |   |
| Loss from operations       |       | $                                       | (3,773     | ) | $ | (3,562 | ) |

 

Revenue from our SCOsourcebusiness increased from $20,000 in the first quarter of fiscal year 2004 to$70,000 for the first quarter of fiscal year 2005.  Revenue in both of the above mentioned fiscalquarters was primarily attributable to sales of our SCOsource IP licenses.  Cost of revenue, which primarily includeslegal and professional fees incurred in connection with the SCO Litigation,decreased slightly from $3,523,000 in the first quarter of fiscal year 2004 to$3,493,000 in the first quarter of fiscal year 2005.  Operating expenses for sales and marketing,research and development and general and administrative increased in the firstquarter of fiscal year 2005 from the first quarter of fiscal year 2004 asadditional employees were included in this business.

 

Our future success with ourSCOsource initiatives and future revenue from SCOsource initiatives will dependon our ability to protect our UNIX intellectual property.

 

Because of the uncertainties related to our SCOsourcebusiness, we are unable to estimate the amount and timing of future SCOsourcelicensing revenue.  This uncertainty representsa significant risk and challenge for us, both in the short and long term.  If we do receive revenue from this source, itmay be sporadic and fluctuate from quarter to quarter.  Our SCOsource initiatives are unlikely toproduce a stable or predictable revenue stream for the foreseeable

 

23

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future.  We areunlikely to generate significant revenue from our SCOsource business unless anduntil we prevail in our litigation against IBM, Red Hat, Novell, DaimlerChrysler and AutoZone (the “SCO Litigation”). Additionally, the success of these initiatives may depend on thestrength of our intellectual property rights and contractual claims regardingUNIX, including the strength of our claim that unauthorized UNIX source codeand derivative works are prevalent in Linux.

 

**CriticalAccounting Policies**

 

Our critical accountingpolicies and estimates include the following:

 

**•**                                          Revenue recognition;

 

**•**                                          Deferred income taxes and related valuationallowances;

 

**•**                                          Severance and exit costs;

 

**•**                                          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 modified by SOP 98-9.  Revenue recognition in accordance with thesepronouncements is complex due to the nature and variability of our salestransactions.  We recognize productsrevenue upon shipment if a signed contract exists, the fee is fixed ordeterminable, collection of the resulting receivable is probable and productreturns are reasonably estimable.

 

The majority of our revenue transactions relate toproduct-only sales.  On occasion we haverevenue transactions that include multiple elements (such as products,maintenance, technical support services and other services).  For software agreements that have multipleelements, we allocate revenue to each component of the contract based on vendorspecific objective evidence (“VSOE”). VSOE is established when such elements are sold separately.  We recognize revenue when the criteria forproduct revenue recognition set forth above have been met.  If VSOE of all undelivered elements exists,but VSOE does not exist for one or more delivered elements, then revenue is recognizedusing the residual method.  Under theresidual method, the fair value of the undelivered elements is deferred and theremaining portion of the license fee is recognized as revenue in the periodwhen persuasive evidence of an arrangement is obtained assuming all otherrevenue recognition criteria are met.  Werecognize revenue allocated to undelivered products when the criteria forrevenue recognition set forth above have been met.

 

Estimates used in revenue recognition include thedetermination of credit-worthiness of our customers, verification of sales-outreporting to end users through our two-tier distribution channel and theestimation of potential returns.  Inaddition to these estimates, we also provide reserves against revenue based onhistorical trends and experience.  To theextent our estimates are incorrect, or we are not able to maintain VSOE, ourrecognized revenue could be adversely impacted and would harm our results ofoperations.  Additionally, if ourbusiness conditions change or our revenue contracts begin to contain moremultiple elements, our revenue recognition in future periods may be impactedbecause a larger component of revenue may be deferred.

 

*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$66,655,000 against our entire net deferred tax asset as of October 31,2004.  The valuation allowance wasrecorded because of our history of net operating losses and the uncertaintiesregarding our future operating profitability and taxable income.

 

24

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

 

Each restructuring has required us to make estimatesand assumptions related to losses on vacated facilities, provisions fortermination benefits, outplacement costs and other costs.  Pursuant to the relevant accountingliterature, we may record an accrual for amounts associated with arestructuring that are not paid in the current period.  We regularly evaluate the adequacy of theaccruals based on changes in estimates. We may incur future charges for new restructuring activities.

 

*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.

 

Write-downs of intangible assets may be necessary ifthe future fair value of these assets is less than carrying value.  If the operating trends for our UNIX orSCOsource businesses continue to decline we may be required to record an impairmentcharge in a future period related to the carrying value of our long-livedassets.

 

*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 lastthree fiscal years.  Our allowance fordoubtful accounts, which is determined based on our historical experience and aspecific review of customer balances, was $152,000 as of January 31,2005.  Our past experience has resultedin minimal differences from the actual amounts provided for bad debts and ourrecorded estimates.  However, our actualbad debts in future periods may differ from our current estimates and thedifferences may be material, which may have an adverse impact on ourfuture accounts receivable and cash position.

 

25

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**Results of Operations**

 

The following table presents our results of operationsfor the three months ended January 31, 2005 and 2004 (in thousands):

 
| ** **                                          | ** ** | **Three Months Ended January 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| **Statement  of Operations Data:**                  |       |                                    |       |   |   |
| ** **                                          |       |                                    |       |   |   |
| Revenue:                                            |       |                                    |       |   |   |
| Products                                            |       | $                                       | 7,304      |   | $ | 9,712 |   |
| SCOsource licensing                                 |       | 70                                      |       | 20 |   |
| Services                                            |       | 1,491                                   |       | 1,660 |   |
| Total revenue                                       |       | 8,865                                   |       | 11,392 |   |
| Cost of revenue:                                    |       |                                    |       |   |   |
| Products                                            |       | 644                                     |       | 805 |   |
| SCOsource licensing                                 |       | 3,493                                   |       | 3,523 |   |
| Services                                            |       | 749                                     |       | 1,322 |   |
| Total cost of revenue                               |       | 4,886                                   |       | 5,650 |   |
| Gross margin                                        |       | 3,979                                   |       | 5,742 |   |
| Operating expenses:                                 |       |                                    |       |   |   |
| Sales and marketing                                 |       | 2,937                                   |       | 5,021 |   |
| Research and development                            |       | 2,080                                   |       | 2,707 |   |
| General and administrative                          |       | 1,763                                   |       | 2,194 |   |
| Amortization of intangibles                         |       | 593                                     |       | 787 |   |
| Stock-based compensation                            |       | 15                                      |       | 435 |   |
| Total operating expenses                            |       | 7,388                                   |       | 11,144 |   |
| Loss from operations                                |       | (3,409                                  | )          | (5,402 | ) |
| Equity in income of affiliate                       |       | 53                                      |       | 37 |   |
| Other income, net                                   |       | 509                                     |       | 3,763 |   |
| Provision for income taxes                          |       | (114                                    | )          | (128 | ) |
| Net loss                                            |       | (2,961                                  | )          | (1,730 | ) |
| Dividends on redeemable convertible preferred stock |       | —                                  |       | (756 | ) |
| Net loss applicable to common stockholders          |       | $                                       | (2,961     | ) | $ | (2,486 | ) |

 

**THREE MONTHS ENDED JANUARY 31, 2005 AND 2004**

 

### ***Revenue***

 
| ** ** | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|------------|------------|----------|------------|------------|------------|----------|------------|
|       |       |     |       |       |       |     |       |
| Revenue    |       | $        | 8,865,000  |       | (22        | )%       | $          | 11,392,000 |   |
|            |            |          |            |            |            |          |            |  |  |

 

Revenue for the first quarter of fiscal year 2005decreased by $2,527,000, or 22 percent, from the first quarter of fiscal year2004.  This decrease was primarilyattributable to a continued decline in our UNIX business.

 

Revenue generated from our UNIX business andSCOsource business is as follows:

 
| ** **               | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|------------|------------|----------|------------|
|                     |       |     |       |       |       |     |       |
| UNIX revenue             |       | $        | 8,795,000  |       | (23        | )%       | $          | 11,372,000 |   |
| Percent of total revenue |       | 99       | %          |       |       | 100      | %          |
| SCOsource revenue        |       | 70,000   |       | 250        | %          | 20,000   |       |
| Percent of total revenue |       | 1        | %          |       |       | 0        | %          |
|                          |            |          |            |            |            |          |            |  |  |

 

26

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Thedecrease in revenue in the UNIX business of $2,577,000 for the first quarter offiscal year 2005 compared to the first quarter of fiscal year 2004 wasprimarily attributable to continued competition from other operating systems,particularly Linux.  We anticipate thatfor the remainder of fiscal year 2005 our UNIX business and the related revenuefrom the UNIX business will face significant competition from Linux and otheroperating systems.

 

Salesof our UNIX products and services during the first quarter of fiscal year 2005were primarily to pre-existing customers. Our UNIX business revenue depends significantly on our ability to marketour products to existing customers and to generate upgrades from existingcustomers.  Our UNIX revenue may be lowerthan currently anticipated if we are not successful with our existing customersor if we lose the support of any of our existing hardware and software vendorsor our key industry partners withdraw their marketing and certification supportor direct their support to our competitors. This may occur as a result of the decline of our UNIX business and ourSCOsource initiatives.

 

*Products Revenue*

 
| ** **               | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|------------|------------|----------|------------|
|                     |       |     |       |       |       |     |       |
| Products revenue         |       | $        | 7,304,000  |       | (25        | )%       | $          | 9,712,000 |   |
| Percent of total revenue |       | 82       | %          |       |       | 85       | %          |
|                          |            |          |            |            |            |          |            |  |  |

 

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, distribution partners and largeaccounts.  We rely heavily on ourtwo-tier distribution channel and any disruption in our distribution channelcould have an adverse impact on future revenue.

 

The decrease in products revenue of $2,408,000 fromthe first quarter of fiscal year 2005 compared to the first quarter of fiscalyear 2004 was primarily attributable to decreased sales of OpenServerand UnixWare products primarily resulting from increased competition in theoperating system market, particularly Linux. We believe that this competition from Linux will continue for the remainderof fiscal year 2005 and future periods.

 

Ourproducts revenue was derived primarily from sales of our OpenServer andUnixWare products.  Other productsrevenue consists mainly of product maintenance and other UNIX-related products.  Revenue for these products was as follows:

 
| ** **                  | ** ** | **2005**  | ** ** | **Change** | ** ** | **2004**  | ** ** |
|-----------------------------|------------|-----------|------------|------------|------------|-----------|------------|
|                        |       |      |       |       |       |      |       |
| OpenServer revenue          |       | $         | 4,013,000  |       | (23        | )%        | $          | 5,202,000 |   |
| Percent of products revenue |       | 55        | %          |       |       | 54        | %          |
| UnixWare revenue            |       | 2,136,000 |       | (22        | )%         | 2,738,000 |       |
| Percent of products revenue |       | 29        | %          |       |       | 28        | %          |
| Other products revenue      |       | 1,155,000 |       | (35        | )%         | 1,772,000 |       |
| Percent of products revenue |       | 16        | %          |       |       | 18        | %          |
|                             |            |           |            |            |            |           |            |  |  |

 

Thedecreases in revenue for OpenServer, UnixWare and other products are allprimarily the result of continued competition from other operating systems,particularly Linux.

 

*SCOsource Licensing Revenue*

 
| ** **                  | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |
| SCOsource licensing revenue |       | $        | 70,000     |       | 250        | %        | $          | 20,000 |   |
| Percent of total revenue    |       | 1        | %          |       |       | 0        | %          |
|                             |            |          |            |            |            |          |            |  |  |

 

27

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We initiated our SCOsource business for the purposeof protecting our intellectual property rights in our UNIX source code andderivative works.  SCOsource IP licensingrevenue was $70,000 in the first quarter of fiscal year 2005 compared torevenue of $20,000 generated in the first quarter of fiscal year 2004.

 

We are unable to predict the amount and timing offuture SCOsource licensing revenue, and when generated, the revenue will besporadic.

 

*Services Revenue*

 
| ** **               | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|------------|------------|----------|------------|
|                     |       |     |       |       |       |     |       |
| Services revenue         |       | $        | 1,491,000  |       | (10        | )%       | $          | 1,660,000 |   |
| Percent of total revenue |       | 17       | %          |       |       | 15       | %          |
|                          |            |          |            |            |            |          |            |  |  |

 

Services revenue consists primarily of annual andincident technical support fees, engineering services fees, professionalservices and consulting fees, and education fees.  These fees are typically charged and invoicedseparately from UNIX products sales.  Thedecrease in services revenue of $169,000, or 10 percent, from the first quarterof fiscal year 2004 as compared to the first quarter of fiscal year 2005, wasin part due to the decrease in products revenue as well as fewer customers renewingservices 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 to renew annual support and services agreements withexisting UNIX customers.

 

*Cost of Products Revenue*

 
| ** **                     | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|------------|------------|----------|------------|
|                           |       |     |       |       |       |     |       |
| Cost of products revenue       |       | $        | 644,000    |       | (20        | )%       | $          | 805,000 |   |
| Percentage of products revenue |       | 9        | %          |       |       | 8        | %          |
|                                |            |          |            |            |            |          |            |  |  |

 

Cost of products revenue consists of manufacturingcosts, royalties to third-party vendors, technology costs and overheadcosts.  Cost of products revenuedecreased by $161,000, or 20 percent, in the first quarter of fiscal year 2005as compared to the first quarter of fiscal year 2004.  This decrease in the dollar amount of cost ofproducts revenue was primarily attributable to lower products revenue, lowermanufacturing costs, decreased royalties to third party vendors and loweramortized technology costs.

 

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

 

*Cost of SCOsource Licensing Revenue*

 
| ** **                                | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|-------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
|                                      |       |     |       |       |       |     |       |
| Cost of SCOsource licensing revenue       |       | $        | 3,493,000  |       | (1         | )%       | $          | 3,523,000 |   |
| Percentage of SCOsource licensing revenue |       | 4990     | %          |       |       | 17615    | %          |
|                                           |            |          |            |            |            |          |            |  |  |

 

28

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Cost of SCOsource licensing revenue includes legaland professional fees incurred in connection with our SCO Litigation, thesalaries and related personnel costs of SCOsource employees, and an allocationof corporate costs.

 

Cost of SCOsource licensing revenue decreased by$30,000, or 1 percent, during the first quarter of fiscal year 2005 as comparedto the first quarter of fiscal year 2004. The increase in costs in the first quarter of fiscal year 2005 comparedto the first quarter of fiscal year 2004 was primarily attributable toincreased legal costs incurred in connection with our SCO Litigation.

 

According to the terms of our Engagement Agreementwith the law firms representing us in our SCO Litigation described in moredetail below in this Item 2 of Part I of this Form 10-Q, weanticipate that the dollar amount of our cost of SCOsource licensing for theremaining quarters of fiscal year 2005 will be generally consistent with thecosts incurred in the first quarter of fiscal year 2005.  However, future legal fees may includecontingency payments made to the law firms as a result of a settlement,judgment, certain licensing fees or a sale of our company, which could causecost of SCOsource licensing revenue to be higher than anticipated.

 

*Cost of Services Revenue*

 
| ** **                     | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|------------|------------|----------|------------|
|                           |       |     |       |       |       |     |       |
| Cost of services revenue       |       | $        | 749,000    |       | (43        | )%       | $          | 1,322,000 |   |
| Percentage of services revenue |       | 50       | %          |       |       | 80       | %          |
|                                |            |          |            |            |            |          |            |  |  |

 

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 $573,000, or 43 percent, for the first quarter offiscal year 2005 compared to the first quarter of fiscal year 2004.  This decrease was attributable toreduced employee and related costs and the elimination of certain third-partysupport contracts.

 

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

 

*Sales and Marketing*

 
| ** **                  | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |
| Sales and marketing expense |       | $        | 2,937,000  |       | (42        | )%       | $          | 5,021,000 |   |
| Percentage of total revenue |       | 33       | %          |       |       | 44       | %          |
|                             |            |          |            |            |            |          |            |  |  |

 

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 expenseof $2,084,000, or 42 percent, from the first quarter of fiscal year 2004compared to the first quarter of fiscal year 2005 and was primarily attributableto reductions in sales and marketing employees, reduced travel expenses, lesscommissions and lower advertising costs. Our sales and marketing full-time equivalent employees decreased from101 as of January 31, 2004 to 50 as of January 31, 2005.

 

For the remaining quarters of fiscal year 2005, weanticipate that the dollar amount of sales and marketing expense will begenerally consistent to that incurred in the first quarter of fiscal year 2005.

 

29

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*Research and Development*

 
| ** **                       | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------|------------|------------|------------|----------|------------|
|                             |       |     |       |       |       |     |       |
| Research and development expense |       | $        | 2,080,000  |       | (23        | )%       | $          | 2,707,000 |   |
| Percentage of total revenue      |       | 23       | %          |       |       | 24       | %          |
|                                  |            |          |            |            |            |          |            |  |  |

 

Research and development expenses consist of thesalaries and benefits of software engineers, consulting expenses and corporateallocations.  Research and developmentexpense decreased by $627,000, or 23 percent, from the first quarter of fiscalyear 2005 compared to the first quarter of fiscal year 2004 and was primarilyattributable to work force reductions. Our research and development full-time equivalent employees decreasedfrom 86 as of January 31, 2004 to 55 as of January 31, 2005.

 

For the remaining quarters of fiscal year 2005, weanticipate that the dollar amount of research and development expense will begenerally consistent to that incurred in the first quarter of fiscal year 2005.

 

*General and Administrative*

 
| ** **                         | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|------------|------------|----------|------------|
|                               |       |     |       |       |       |     |       |
| General and administrative expense |       | $        | 1,763,000  |       | (20        | )%       | $          | 2,194,000 |   |
| Percentage of total revenue        |       | 20       | %          |       |       | 19       | %          |
|                                    |            |          |            |            |            |          |            |  |  |

 

General and administrative expenses consist of thesalaries and benefits of finance, human resources, and executive management andexpenses for professional services and corporate allocations.  General and administrative expense decreased by$431,000, or 20 percent, during the first quarter of fiscal year 2005 ascompared to the first quarter of fiscal year 2004.  The decrease in general and administrativeexpense was primarily attributable to lower personnel and related costs anddecreased professional service fees attributed to accounting and legalwork.  Our general and administrativefull-time equivalent employees decreased from 54 as of January 31, 2004 to31 as of January 31, 2005.

 

For the remaining quarters of fiscal year 2005, we anticipatethat the dollar amount of general and administrative expenses will be generallyconsistent to that incurred in the first quarter of fiscal year 2005.  However, due to the new compliance andreporting regulations under the Sarbanes-Oxley Act and other new regulatoryrequirements, general and administrative expenses may vary as we implementpolicies and procedures to comply with these new requirements.

 

*Severance and Exit Costs*

 

We did not incur any severance and exit costs duringthe first quarter of fiscal year 2005 or 2004.  The activity related to the accrual forseverance and exit costs is as follows for the first quarter of fiscal year2005 (in thousands):

 
| ** **                  | ** ** | **Balance at  November 1, 2004** | ** ** | **Additions** | ** ** | **Utilization** | ** ** | **Balance at  January 31, 2005** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|---------------|------------|-----------------|------------|---------------------------------------|------------|
|                        |       |                                  |       |          |       |            |       |                                  |       |
| Ongoing severance and other |       | $                                     | 401        |          | $          | —          |       | $                                     | (233       | ) | $ | 168 |   |
|                             |            |                                       |            |               |            |                 |            |                                       |            |  |  |  |  |

 

Amountsto be paid for severance and exit costs are included as accrued liabilities andare expected to be paid in the second quarter of fiscal year 2005.

 

30

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*Amortization of Intangibles*

 
| ** **                               | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
|                                     |       |     |       |       |       |     |       |
| Amortization of goodwill and intangibles |       | $        | 593,000    |       | (25        | )%       | $          | 787,000 |   |
| Percentage of total revenue              |       | 7        | %          |       |       | 7        | %          |
|                                          |            |          |            |            |            |          |            |  |  |

 

During the first quarterof fiscal years 2005 and 2004, we recorded $593,000 and $787,000, respectively,for the amortization of intangible assets with finite lives.  The decrease of $194,000, or 25 percent, fromthe first quarter of fiscal year 2005 compared to the first quarter of fiscalyear 2004 was primarily attributable to reduced amortization expense recordedon certain assets acquired from Vultus, Inc. in June 2003 that werewritten down to $0 during fiscal year 2004.

 

*Stock-basedCompensation*

 
| ** **                  | ** ** | **2005** | ** ** | **Change** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|------------|------------|----------|------------|
|                        |       |     |       |       |       |     |       |
| Stock-based compensation    |       | $        | 15,000     |       | (97        | )%       | $          | 435,000 |   |
| Percentage of total revenue |       | 0        | %          |       |       | 4        | %          |
|                             |            |          |            |            |            |          |            |  |  |

 

Stock-basedcompensation consisted of the following components for the first quarter offiscal years 2005 and 2004 (in thousands):

 
| ** **                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |
| Amortization of stock-based compensation  |       | $        | 15         |     | $          | 110 |   |
| Options, warrants and shares for services |       | —   |       | 233      |       |
| Modifications to options                  |       | —   |       | 92       |       |
| Total                                     |       | $        | 15         |     | $          | 435 |   |

 

As of January 31,2005, there was a balance of approximately $7,000 in deferred compensation thatwill be amortized to stock-based compensation during fiscal year 2005.

 

*Equity inIncome (Losses) of Affiliate*

 

We account for our ownership interests in companies inwhich we own at least 20 percent and less than 50 percent using the equitymethod of accounting.  Under the equitymethod, we record our portion of the entities’ net income or net loss in ourconsolidated statements of operations. As of January 31, 2005, the carrying value of our investments wasrelated to our 30 percent ownership in a Chinese company.

 

Duringthe first quarter of fiscal years 2005 and 2004, we recorded $53,000 and37,000, respectively, that related to equity in income of this entity.

 

*OtherIncome (Expense), net*

 

Otherincome (expense) consisted of the following components for the first quarter offiscal years 2005 and 2004 (in thousands):

 
| ** **                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
|                               |       |     |       |     |       |
| Interest income                    |       | $        | 37         |     | $          | 270 |   |
| Change in fair value of derivative |       | —   |       | 3,624    |       |
| Other income (expense), net        |       | 472      |       | (131     | )          |
| Total                              |       | $        | 509        |     | $          | 3,763 |   |

 

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Interestincome decreased by $233,000 from the first quarter of fiscal year 2004 to thefirst quarter of fiscal year 2005 and was primarily attributable to a decreasein our cash and available-for-sale securities balances.

 

Theincome recorded on the change in fair value of derivative for the first quarterof fiscal year 2004 related to the decrease in fair value of this instrumentand marking it to market at each balance sheet date.  The derivative financial instrument was eliminatedduring the second quarter of fiscal year 2004.

 

Theincrease in other income (expense), net, was primarily attributable to thecollection of a note receivable from Vintela, Inc. (“Vintela”) asdescribed in more detail in Note 8 to our financial statements above in Part I,Item 1 of this Form 10-Q.  TheVintela note receivable was originally received in April 2003, but becausewe received the note receivable in exchange for the transfer of certainsoftware to a related party and there was substantial doubt concerning theability of Vintela to repay the note, no gain was recognized until the firstquarter of fiscal year 2005 when we received payment.

 

*Provision for Income Taxes*

 

The provision for income taxes was $114,000 in thefirst quarter of fiscal year 2005 and $128,000 in the first quarter of fiscalyear 2004.  Our provision for income taxes is primarily related to earningsin foreign subsidiaries.

 

### ***Dividends Related to Series AConvertible Preferred****Stock*

### ** **

In October 2003, we issued 50,000 shares of our Series AConvertible Preferred Stock for $1,000 per share.  We accrued dividends on the Series Ashares of $756,000 for the three months ended January 31, 2004.  All Series A shares were retired duringfiscal year 2004, and there were no dividends incurred during the three monthsended January 31, 2005.

 

**Liquidityand Capital Resources**

 

As a result of the Engagement Agreement between us andour Law Firms, we anticipate using cash of approximately $11,000,000 in thedefense of the SCO Litigation during the remainder of the year ending October 31,2005, which would leave us approximately $9,230,000 in cash for our businessoperations.  We expect that our UNIXbusiness will generate sufficient cash in the year ending October 31, 2005to cover our internal costs related to our SCOsource initiatives and the SCOLitigation, and believes that we will have sufficient cash resources to fundour operations through October 31, 2005.

 

In theevent that cash required to fund operations and strategic initiatives exceedsour current cash resources and cash generated from operations, we will berequired to reduce costs and perhaps raise additional capital.  We may not be able to reduce costs in amanner that does not impair our ability to maintain our UNIX business andpursue our SCOsource initiatives.  We mayalso not be able to raise capital for any number of reasons including thoselisted under the section ”Risk Factors” below.  If additional equity financing is available,it may not be available to us on attractive terms and may be dilutive to ourexisting stockholders.  In addition, ifour stock price declines, we may not be able to access the public equitymarkets on acceptable terms, if at all. Our ability to effect acquisitions for stock would also be impaired.

 

Ourcash and equivalents balance decreased from $12,693,000 as of October 31,2004 to $9,486,000 as of January 31, 2005. During this same time period, our investment in available-for-salesecurities decreased from $18,756,000 to $5,946,000.  Total cash and equivalents and

 

32

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available-for salesecurities were $15,432,000 as of January 31, 2005.  We also have $4,798,000 classified as acomponent of restricted cash set aside to cover expert, consulting and otherexpenses related to our SCO Litigation. During the first quarter of fiscal year 2005, we expended a significantamount of cash to pay accounts payable and accrued liabilities related to ourintellectual property litigation.  Weintend to use the cash and equivalents and available-for-sale securities as of January 31,2005 to maintain our UNIX business and pursue our SCO Litigation.

 

Ournet cash used in operations during the first quarter of fiscal year 2005 was$16,596,000 and was attributable to a net loss of $2,961,000, non-cash items of$746,000 and changes in operating assets and liabilities of $14,381,000.  Our working capital decreased from$15,413,000 as of October 31, 2004 to $13,813,000 as of January 31,2005.

 

Our net cash used in operations during thefirst quarter of fiscal year 2004 was $4,319,000.  Cash used in operations was attributable to anet loss of $1,730,000, non-cash expenses of $2,103,000 and from changes inoperating assets and liabilities of $486,000.

 

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 2005, cash provided by investing activities was $12,765,000, whichwas primarily a result of sales, net of purchases, of available-for-salesecurities, of $12,810,000, which was offset by purchases of equipment of$45,000.

 

Duringthe first quarter of fiscal year 2004, cash used in investing activities was$13,752,000, which was primarily a result of our purchase of available-for-salesecurities of $14,989,000 and equipment purchases of $131,000, offset byproceeds received from the sale of available-for-sale securities of $1,368,000.

 

Ourfinancing activities provided $571,000 of cash in the first quarter of fiscalyear 2005.  The primary sources of cashwere from the exercise of options to acquire common stock of $198,000 andproceeds of $373,000 received from the sale of common stock through our ESPP.

 

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 ESPP of $370,000.

 

Our net accounts receivable balance decreased from$6,638,000 as of October 31, 2004 to $5,953,000 as of January 31,2005, primarily as a result of lower invoicing and revenue in the first quarterof fiscal year 2005 as compared to the fourth quarter of fiscal year 2004.  The majority of our accounts receivable arecurrent and our allowance for doubtful accounts was $152,000 as of January 31,2005, which represented approximately 2 percent of our gross accountsreceivable balance.  This percentage ofgross accounts receivable is consistent with our experience in prior periods,and we expect this trend to continue. Our write-offs of uncollectible accounts during the first quarter offiscal year 2005 were not significant.

 

On October 31, 2004, weentered into the Engagement Agreement with the law firms representing us in theSCO Litigation (the “Law Firms”).  TheEngagement Agreement governs the relationship between us and the Law Firms inconnection with their representation of us in the SCO Litigation, through theend of the current litigation between us and IBM.  Our purpose in entering into this EngagementAgreement was to limit the cash expenditures needed to pursue the SCOLitigation.  The Engagement Agreementprovides for the payment of approximately $26,000,000 for attorney fees inconnection with the SCO Litigation through the end of the current litigationbetween us and IBM and the escrow of at least $5,000,000 for the payment of anyexpert,

 

33

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consulting and otherexpenses.  As of January 31, 2005,we had paid $202,000 of expenses and the remaining $4,798,000 was classified asa component of restricted cash.

 

Future legal fees covered under the EngagementAgreement requires us to pay to the Law Firms $2,000,000 per quarter for eachsuccessive quarter which began September 1, 2004 and will end December 1,2005 for a total amount of $12,000,000. In the first quarter of fiscal year 2005, we made the quarterly paymentsfor September 2004 as well as December 2004 for a total of$4,000,000.  The payment of these feeshas had and will continue to have a material impact on our cash position.

 

In addition to the cashexpenditures mentioned above, we must also pay one or more contingency feesupon any amount we or our stockholders may receive as a recovery from ourlitigation, our intellectual property licensing or a sale of our company.  The contingency fee amounts payable to theLaw Firms will be, subject to certain credits and adjustments, as follows:

 

**•**                  33percent of any aggregate recovery amounts received up to $350,000,000;

 

**•**                  plus25 percent of any aggregate recovery amounts above $350,000,000 but less thanor equal to $700,000,000;

 

**•**                  plus20 percent of any aggregate recovery amounts in excess of $700,000,000.

 

The Engagement Agreementspecifically provides that, except for the compensation obligationsspecifically described above, we will not be obligated to pay any legal fees,whether hourly, contingent or otherwise, to the Law Firms, or any other lawfirms that may be engaged by the Law Firms, in connection with the SCOLitigation through the end of the current litigation between us and IBM,including any appeals.

 

We have entered intooperating leases for our corporate offices located in the United States and ourinternational sales offices.  We havecommitments under these leases that extend through fiscal year 2010.

 

The following tablesummarizes our contractual operating lease obligations and our requiredpayments to the Law Firms as of January 31, 2005:

 
| ** **                  | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1 - 3 years** | ** ** | **More than  3 years** | ** ** |
|-----------------------------|------------|-----------|------------|-----------------------|------------|-----------------|------------|------------------------|------------|
|                        |       |      |       |                  |       |            |       |                   |       |
| Operating lease obligations |       | $         | 4,352,000  |                  | $          | 1,661,000       |       | $                      | 2,598,000  |   | $ | 93,000 |   |
| Payments to Law Firms       |       | 8,000,000 |       | 6,000,000             |       | 2,000,000       |       | —                 |       |
| Total obligations           |       | $         | 12,352,000 |                  | $          | 7,661,000       |       | $                      | 4,598,000  |   | $ | 93,000 |   |
|                             |            |           |            |                       |            |                 |            |                        |            |  |  |  |  |  |  |  |

 

As of January 31, 2005, we did not have anylong-term debt obligations, purchase obligations, other long-term liabilitiesor material capital lease obligations.

 

Our ability to cut costs to offset revenue declines inour UNIX business is limited because of contractual commitments to maintain andsupport our existing UNIX customers.  This decline in our UNIX business may beaccelerated if industry partners withdraw their support as a result of ourSCOsource initiatives.  Our SCOsourceinitiatives may cause industry partners, developers and hardware and softwarevendors to choose not to support or certify to our UNIX operating systemproducts.  This would lead to anaccelerated decline in our UNIX products and services revenue.  If our UNIX products and servicesrevenue is less than expected, our liquidity will be adversely impacted.

 

34

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We have issued shares and granted options under ourEquity Compensation Plans without complying with registration or qualificationrequirements under federal securities laws and the securities laws of certainstates.  As a result, certain planparticipants have a right to rescind their purchases of shares under the EquityCompensation 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 participantsother than rescission claims.

 

If our potential rescission offer is made and acceptedby plan participants holding shares acquired under the Equity CompensationPlans or otherwise entitled to recover damages from us in respect of suchshares they have sold, or such plan participants otherwise make rescissionclaims against us, we could be required to make aggregate payments to theseplan participants of up to $893,000 in the aggregate, excluding interest andother possible fees, based upon shares outstanding under the EquityCompensation Plans as of January 31, 2005.

 

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 be required to pay interest and penaltiesup to statutory limits in connection with plan participants making rescissionclaims or in connection with any rescission offer.  We believe that it is reasonably possiblethat we may be required to pay interest and penalties, but are not able toestimate an amount.

 

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

 

*Foreign Currency Risk. *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.  Our international revenueis denominated in U.S. dollars, Euros and United Kingdom Pounds.  Most of the operating expenses related to ourforeign-based operations are denominated in foreign currencies and thereforeoperating results are affected by changes in the U.S. dollar exchange rate inrelation to foreign currencies such as the Euro, among others.  If the U.S. dollar further weakens comparedto the 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 have in the past utilized foreign currency forwardexchange contracts for market exposures of underlying assets andliabilities.  We do not use forwardexchange contracts for speculative or trading purposes.  Our accounting policies for foreign exchangecontracts are based on our designation of each contract.  The criteria we use for designating eachcontract include such contract’s effectiveness in risk reduction and one-to-onematching of forward exchange contracts to underlying assets andliabilities.  Gains and losses oncurrency forward contracts that are firm commitments are deferred andrecognized in income in the same period that the underlying transactions aresettled.  Gains and losses on currencyforward contracts that are designated and effective for existing transactionsare recognized in income in the same period

 

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as losses and gains on the underlying transactions arerecognized and generally offset.  Gainsand losses on any instruments not meeting the above criteria are recognized inincome in the current period.  As of January 31,2005, we had no outstanding instruments classified as hedges.

 

*Interest Rate Risk. *The primary objective of our cash management strategyis to invest available funds in a manner that assures maximum safety and liquidityand maximizes yield within such constraints. We believe that a hypothetical movement in interest rates, either up ordown, would not have a material adverse impact on our cash and equivalent sandavailable-for-sale securities.  We do notborrow money for short-term investment 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, 2005, our investmentsbalance was approximately $613,000 and was related to our investment in a 30percent owned Chinese company.

 

The stock market in general, and the market for sharesof technology companies in particular, has experienced price fluctuations.  In addition, factors such as new productintroductions by our competitors or developments in the litigation related toour SCOsource initiatives may have a significant impact on the market price ofour common stock.  Furthermore,quarter-to-quarter fluctuations in our results of operations may have asignificant impact on the market price of our common stock.  These conditions could cause the price of ourcommon stock to fluctuate substantially over short periods of time.

 

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

 

*Evaluation of disclosure controls andprocedures. *Under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, we evaluated the effectivenessof the design and operation of our disclosure controls and procedures (asdefined in Rule 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934 (the “Exchange Act”)).  Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that, as of the end ofthe period covered by this report and as a result of the material weakness inour internal controls described below, our disclosure controls and procedureswere not effective to ensurethat information required to be disclosed by us in the reports we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in applicable rules and forms.

 

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 we received uponpurchase of such shares must be reclassified from permanent equity to temporaryequity.  As of January 31, 2005, werecorded temporary equity of $893,000 related to certain shares of common stockissued under our Equity Compensation Plans that are subject to rescission.  We determined that we lacked procedures toreconcile shares issued with shares available under registration statements ina timely manner.

 

Our internal controls over financial reportingidentified the preceding error prior to the completion of the financialstatements as of and for the three months ended January 31, 2005.  We have discussed these matters with theAudit Committee of the Board of Directors and with KPMG LLP, our independentauditors.  In response, subsequent to January 31,2005, we have

 

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implemented in our internal control proceduresadditional detail transactional controls, an equity compliance checklist andadditional review and approval procedures.

 

*Changes in internal control over financialreporting. *During themost recent quarter ended January 31, 2005, there has been no change inour internal control over financial reporting (as defined in Rule 13a-15(f) and15d-15(f) under the Exchange Act) that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.  However, as discussed above,changes have been implemented subsequent to the period covered by this Form 10-Qto add additional controls to correct the material weakness in internal controlover financial reporting.

 

#### ***Forward-Looking Statements***and Factors That May Affect Future Results andFinancial Condition

#### *** ***

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

#### *** ***

**•**                              Our operating strategy to continue to support our existing users of ourUNIX operating system products and to pursue SCOsource licensing opportunitiesand protect our intellectual property rights;

 

**•**                              Our intention to continue to maintain our core UNIX business in fiscalyear 2005 by continuing our research and development efforts;

 

**•**                              Our belief that our OpenServer and UnixWare products will continue toprovide a revenue stream in fiscal year 2005 and our belief that revenue fromsuch products will continue to decline;

 

**•**                              Our expectation that our sales channel should continue to providereliable UNIX operating systems for small-to-medium sized business customers;

 

**•**                              Our intention to focus our development resources on our next OpenServerproduct and maintaining our current UnixWare products;

 

**•**                              Our expectation that hardware and software vendors, as well as softwaredevelopments, will continue to turn their certification and applicationdevelopment efforts toward Linux and elect not to continue to support orcertify to our UNIX operating system products;

 

**•**                              Our intention to release SCO OpenServer 6 in the first half of calendaryear 2005 and our expectation that our investment in this effort will givecustomers confidence in our technology;

 

**•**                              Our intention to continue to pursue our SCOsource initiatives in fiscalyear 2005;

 

**•**                              Our belief that the future success of our SCOsource initiatives willdepend on our ability to protect our intellectual property;

 

**•**                              Our intention to vigorously defend legal claims and counterclaimsbrought against us by others;

 

**•**                              Our intention to continue to pursue the SCO Litigation;

 

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**•**                              Our belief that if a rescission offer is made to cure potentialsecurities violations that such rescission offer will not have a materialeffect on our cash balance or financial position;

 

**•**                              Our expectation that our UNIX business will generate positive cash flowduring fiscal year 2005;

 

**•**                              Our belief that our allowance and bad debts for accounts receivablewill remain consistent with our prior experience;

 

**•**                              The strength of our intellectual property rights and contractual claimsregarding UNIX generally and specifically the strength of our claim thatunauthorized UNIX source code and derivatives of UNIX source code are prevalentin Linux;

 

**•**                              Our expectation that total UNIX revenue for fiscal year 2005 willdecline from UNIX revenue generated in fiscal year 2004;

 

**•**                              Our belief that competition from Linux will continue in fiscal year2005 and future periods;

 

**•**                              Our expectation that we will continue to be unable to predict theamount and timing of SCOsource licensing revenue, and when generated, therevenue will be sporadic;

 

**•**                              Our expectation that future services revenue will depend in part on ourability to generate UNIX products revenue from new customers as well as therenewal of annual support and services agreements from existing UNIX customers;

 

**•**                              Our expectation for the remaining quarters of fiscal year 2005 that thedollar amount of our cost of products revenue will be generally consistent tothat generated in the first quarter of fiscal year 2005;

 

**•**                              Our expectation for the remaining quarters of fiscal year 2005 that thedollar amount of our cost of services revenue will be generally consistent tothat generated in the first quarter of fiscal year 2005;

 

**•**                              Our expectation for the remaining quarters of fiscal year 2005 that thedollar amount of our sales and marketing expenses will be generally consistentto that generated in the first quarter of fiscal year 2005;

 

**•**                              Our expectation for the remaining quarters of fiscal year 2005 that thedollar amount of our research and development expenses will be generallyconsistent to that generated in the first quarter of fiscal year 2005;

 

**•**                              Our expectation for the remaining quarters of fiscal year 2005 that thedollar amount of our general and administrative expenses will be generally consistentto that generated in the first quarter of fiscal year 2005;

 

**•**                              Our belief that our legal costs related to our intellectual propertylitigation for the remaining quarters of fiscal year 2005 will be generallyconsistent to that generated in the first quarter of fiscal year 2005,exclusive of any contingent payments;

 

**•**                              Our expectation that ourUNIX business will generate sufficient cash in the year ending October 31,2005 to cover our internal costs related to our SCOsource initiatives and theSCO Litigation, and our belief that we will have sufficient cash resources tofund our operations through October 31, 2005.

 

**•**                              Our belief that certain legal actions to which we are a party will nothave a material adverse effect on us.

 

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We wish to caution readersthat our operating results are subject to various risks and uncertainties thatcould cause our actual results and outcomes to differ materially from thosediscussed or anticipated, including the success of our SCOsource initiatives,competition from other operating systems, particularly Linux, the amount andtiming of SCOsource licensing revenue, our ability to enhance our UNIXoperating systems and maintain our UNIX 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 this report.  We assume no obligation to update or revisethese forward-looking statements to reflect new events or circumstances or anychanges in our beliefs or expectations, other than as required by law.

 

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

#### *** ***

*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 fiscal year 2004, we incurred a net lossfrom operations of $28,573,000 and our accumulated deficit as of October 31,2004 was $224,216,000.  For the firstquarter of fiscal year 2005 we incurred a net loss from operations of$3,409,000 and had an accumulated deficit of $227,177,000.

 

If our revenue from the sale of our UNIX products andservices continues to decline, we will need to further reduce operatingexpenses to generate positive cash flow. We may not be able to further reduce operating expenses without damagingour ability to support our existing UNIX business.  Additionally, we may not be able to achieveprofitability through additional cost-cutting actions.

 

Our UNIX products and services revenue has declinedover the last several years primarily as a result of increased competition fromalternative operating systems, particularly Linux.  In our quarterly results of operations, werecognize revenue from agreements for support and maintenance contracts andother long-term contracts that have been previously invoiced and are includedin deferred revenue.  Our future UNIXrevenue may be adversely impacted and may continue to decline if we are unableto replenish these deferred revenue balances with long-term maintenance andsupport contracts or replace them with other sustainable revenue streams.  If we are unable to generate positive cashflow and profitable operations, our operations will be adversely impacted.

 

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

 

We continue to pursue our SCO Litigation and believevery strongly in the merits of our cases. In our action against IBM, we seek damages for claims generally relatingto our allegation that IBM has inappropriately used and distributed our UNIXsource code and derivative works in connection with its efforts to promote theLinux operating system.  IBM hasresponded to our claims and brought counterclaims against us assertinggenerally that we do not have the right to assert claims based on our ownershipof UNIX intellectual property against IBM or others in the Linux market.  Discovery is continuing in the case, andseveral motions are currently pending before the court.  If we do not prevail in our action againstIBM, or if IBM is successful in its counterclaims against us, our business andresults of operations would be materially harmed and we may not be able tocontinue in business.  The litigationwith IBM and others will be costly, and our costs for legal fees have been andwill continue to be substantial and may exceed our capital resources.Additionally, the market price of our common stock may be negatively affectedas a result of developments in our legal action against IBM that may be, or maybe perceived to be, adverse to us.

 

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As a result of our SCO Litigation and our otherSCOsource initiatives, several participants in the Linux industry and othersaffiliated with IBM or sympathetic to the Linux movement have taken actionsattempting to negatively affect our business and our SCOsource efforts.  Linux proponents have taken a broad range ofactions against us, including, for example, attempting to influenceparticipants in the markets in which we sell our products to reduce oreliminate the amount of our products and services they purchase from us.  We expect that similar efforts likely willcontinue.  There is a risk thatparticipants in our marketplace will negatively view our action against IBM,Novell, DaimlerChrysler and AutoZone and our other SCOsource initiatives, andwe may lose support from such participants.  Any of the foregoing could adversely affectour position in the marketplace, our results of operations and our stock priceand our ability to stay in business.

 

As a further response to our SCOsource initiatives andclaim that our UNIX source code and derivative works have inappropriately beenincluded in Linux, Novell has publicly asserted its belief that it owns certaincopyrights in our UNIX source code, and it has filed 15 copyright applicationswith the United States Copyright Office related to UNIX.  Novell also claims that it has a license toUNIX from us and the right to authorize its customers to use UNIX technology intheir internal business operations. Specifically, Novell has also claimed to have retained rights related tolegacy UNIX SVRx licenses, including the license with IBM.  Novell asserts it has the right to takeaction on behalf of SCO in connection with such licenses, including terminationrights.  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 (now Tarantella, Inc.) in May 2001,which had previously acquired all such assets and rights from Novell in September 1995pursuant to an asset purchase agreement, as amended.  In January 2004, in response to Novell’sactions, we brought suit against Novell for slander of title seeking relief forNovell’s alleged bad faith effort to interfere with our copyrights and contractrights related to our UNIX source code and derivative works and our UnixWareproducts.

 

Notwithstanding our assertions of full ownership ofUNIX-related intellectual property rights, as set forth above, includingcopyrights, and even if we are successful in our legal action against Novelland end users such as AutoZone and DaimlerChrysler, the efforts of Novell andthe other Linux proponents described above may cause Linux end users to be lesswilling to purchase from us our SCOsource IP licenses authorizing their use ofour intellectual property contained in the Linux operating system, which hasand may continue to adversely affect our revenue from our SCOsourceinitiatives.  These efforts of Linuxproponents also may increase the negative view some participants in ourmarketplace have regarding our SCO Litigation and regarding our SCOsourceinitiatives and may contribute to creating confusion in the marketplace aboutthe validity of our claim that the unauthorized use of our UNIX source code andderivative works in Linux infringes on our copyrights.  Increased negative perception and potentialconfusion about our claims in our marketplace could impede our continuedpursuit of our SCOsource initiatives and negatively impact our business.

 

*Our Engagement Agreement with theLaw Firms will require us to spend a significant amount of cash during fiscalyear 2005 and could harm our liquidity position.*

 

As of January 31, 2005, we had a total of$15,432,000 in cash and cash equivalents and available-for-sale securities andan additional $4,798,000 as restricted cash to be used in our operations andpursue the SCO Litigation.  As a resultof the Engagement Agreement between us and the Law Firms, for the remainder offiscal year 2005 we anticipate spending approximately $11,000,000 in thedefense of our intellectual property litigation during fiscal year 2005, whichwould leave us approximately $9,230,000 in cash for our business operations.  We expect that our

 

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UNIX business will generate sufficient cash in fiscalyear 2005 to cover our internal costs related to our SCOsource initiatives andintellectual property litigation. However, if our UNIX business does not generate cash or we spendadditional cash on the SCO Litigation or additional matters, our cash positionwould be negatively impacted, and our ability to pursue our UNIX businessobjectives and our SCO Litigation could be harmed.

 

*Ourfuture SCOsource licensing revenue is uncertain.*

 

We initiated the SCOsource licensing effort in fiscalyear 2003 to review the status of UNIX licensing and sublicensingagreements.  This effort resulted in theexecution of two significant vendor license agreements during fiscal year 2003and generated $25,846,000 in revenue. During fiscal year 2004, our SCOsource licensing revenue declinedsignificantly and was only $829,000.  Dueto a lack of historical experience and the uncertainties related to SCOsourcelicensing revenue, we are unable to estimate the amount and timing of futureSCOsource licensing revenue, if any.  Ifwe do receive revenue from this source, it may be sporadic and fluctuate fromquarter to quarter.  Our SCOsourceinitiatives are unlikely to produce stable, predictable revenue for theforeseeable future.  Additionally, thesuccess of these initiatives may depend on the strength of our intellectualproperty rights and contractual claims regarding UNIX, including the strengthof our claim that unauthorized UNIX source code and derivatives are prevalentin Linux.

 

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

 

Thedecline in our UNIX business and our SCOsource initiatives may cause industrypartners, developers and hardware and software vendors to choose not to supportor certify to our UNIX operating system products.  This would lead to an accelerated decline inour UNIX products and services revenue and would adversely impact our resultsof operations and liquidity.

 

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

 

In August 2003,Red Hat brought a lawsuit against us asserting that the Linux operating systemdoes not infringe on our UNIX intellectual property rights and seeking adeclaratory judgment for non-infringement of copyrights and no misappropriationof trade secrets.  In addition, Red Hatclaims we have engaged in false advertising in violation of the Lanham Act,deceptive trade practices, unfair competition, tortious interference withprospective business opportunities, and trade libel and disparagement.  Although this case is currently stayedpending the resolution of our suit against IBM, we intend to vigorously defendthis action.  However, if Red Hat issuccessful in its claim against us, our business and results of operationscould be materially harmed.

 

Inaddition, regulators or others in the Linux market and some foreign regulatorshave initiated or in the future may initiate legal actions against us, all ofwhich may negatively impact our operations and 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 operating results or our failure to meet the expectations of analysts orinvestors, even in the short-term, could cause our stock price to declinesignificantly. Because of the potential for significant fluctuations in ourSCOsource licensing revenue in any particular period, you should not rely oncomparisons of our results of operations as an indication of futureperformance.

 

Factorsthat may affect our results include:

 

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**•**                                          our abilityto successfully negotiate and complete licensing and other agreements relatedto our intellectual property;

 

**•**                                          the interestlevel of resellers in recommending our UNIX business solutions to end users;

 

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

 

**•**                                          changes ingeneral economic conditions, such as recessions, that could affect capitalexpenditures in the software industry;

 

**•**                                          results of,or developments in our SCO Litigation;

 

**•**                                          changes inbusiness attitudes toward UNIX as a viable operating system compared to othercompeting systems, especially Linux;

 

**•**                                          thecontingency and other legal fees we may pay to the Law Firms representing us inour efforts to establish our intellectual property rights; and

 

**•**                                          changes inattitudes of customers and partners due to the decline in our UNIX business andour aggressive position against the inclusion of our UNIX code and derivativeworks in Linux.

 

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

 

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

 

*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 theoperating system market, our competitors include IBM, Red Hat, Novell, Hewlett-Packard,Sun, Microsoft and other Linux distributors. These and other competitors are aggressively pursuing the current UNIXoperating system market.  Many of thesecompetitors have access to substantially greater resources than we do.  The major competitive alternative to our UNIXproducts is Linux.  The expansion of ourcompetitors’ offerings may restrict the overall market available for our UNIXproducts, including some markets where we have been successful in the past.

 

Ourfuture success may depend in part on our ability to continue to meet theincreasing needs of our customers by supporting existing and emergingtechnologies.  If we do not enhance ourproducts to meet these evolving needs, we may not remain competitive and beable to grow our business.  Additionally,because technological advancement in the UNIX operating system market andalternative operating system markets is progressing at an advanced pace, wewill have to develop and introduce enhancements to our existing products andany new products on a timely basis to keep pace with these developments,evolving industry standards and changing customer requirements.  Our failure to meet any of these and othercompetitive pressures may render our

 

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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 recent years, we have seen hardware andsoftware vendors as well as software developers turn their certification andapplication development efforts toward Linux and elect not to continue tosupport or certify to our UNIX operating system products.  If this trend continues, our competitiveposition will be adversely impacted and our future revenue from our UNIXbusiness will decline.  The decline inour UNIX business may be accelerated if industry partners withdraw theirsupport from us for any reason, including our SCOsource initiatives.

 

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

 

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

 

*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 solutionproviders also purchase solutions through our resellers, and we anticipate theywill continue to do so.  Because weusually sell indirectly through resellers, we cannot control the relationshipsthrough which resellers, solution providers or equipment integrators purchaseour products.  In turn, we do not controlthe presentation of our products to end users. Therefore, our sales could be affected by disruptions in the relationshipsbetween us and our resellers, between our resellers and solution providers, orbetween solution providers and end users. Also, resellers and solution providers may choose not to emphasize ourproducts to their customers.  Any ofthese occurrences could diminish the effectiveness of our distribution channeland lead to decreased sales.

 

*OurEngagement Agreement with the Law Firms representing us to enforce ourintellectual property rights may reduce our ability to raise additionalfinancing.*

 

OurEngagement Agreement with the Law Firms could inhibit our ability to raise additionalfunding if needed.  Although under theEngagement Agreement our obligations to the Law Firms are limited toapproximately $26,000,000 related to certain previously accrued and all futureattorney fees and the escrow of $5,000,000 for the payment of any expert,consulting and other expenses to pursue the SCO Litigation, the agreementprovides that the Law Firms will receive a contingency fee that may range from20 to 33 percent of the proceeds from specified events related to theprotection of our intellectual property rights. Events triggering a contingency fee may include settlements or judgmentsrelated to the SCO Litigation, certain licensing fees, subject to certainexceptions, and a sale of our company. Future payments payable to the Law Firms under this arrangement will besignificant.  The Law Firms’ right toreceive such contingent payments could

 

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cause prospectiveinvestors to choose not to invest in our company or limit the price at whichnew investors would be willing to provide additional funds to our company.

 

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

 

Wehave foreign operations, including development facilities, sales personnel andcustomer support operations in Europe, Latin America and Asia.  These foreign operations are subject tocertain inherent risks, including:

 

**•**                                          potential lossof developed technology through piracy, misappropriation, or more lenient lawsregarding intellectual property protection;

 

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

 

**•**                                          fluctuationsin currency exchange rates and economic instability;

 

**•**                                          longerpayment cycles for sales in foreign countries; and

 

**•**                                          seasonalreductions in business activity.

 

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 maylead to increased governmental ownership or regulation of the economy, higherinterest rates, increased barriers to entry such as higher tariffs and taxes,and reduced demand for goods manufactured in the United States, resulting inlower revenue.

 

Duringthe second quarter of fiscal year 2004, our Indian office was given awithholding tax assessment from the Government of India Income TaxDepartment.  The Tax Department assesseda 15 percent withholding tax on certain revenue transactions in India that theTax Department deemed royalty revenue under the Income Tax Act.  We have filed an appeal with the TaxDepartment and believe that our packaged software does not qualify fortreatment as royalties and therefore would not be subject to withholdingtax.  However, we may be unsuccessful inour appeal against the Tax Department and be obligated to pay the assessedtaxable amounts.  If other countries inwhich we have international operations, such as India, continue to develop andbegin enforcing their tax regimes, we may be subject to withholding or othertaxes.

 

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

 

We needto retain our management, technical, and support personnel.  Competition for qualified professionals inthe software industry is intense, and departures of existing personnel could bedisruptive to our business and might result in the departure of otheremployees.  The loss or departure of anyofficers or key employees could harm our ability to implement our business planand could adversely affect our operations. Our future success depends to a significant extent on the continuedservice and coordination of our management team, particularly Darl C. McBride,our President and Chief Executive Officer.

 

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

 

We have issued shares andoptions granted under our Equity Compensation Plans without complying withregistration or qualification requirements under federal securities laws andthe securities laws of certain states. As a result, certain plan participants that have acquired shares issuedunder the Equity Compensation Plans have rescission rights against us, subjectto applicable statutes of limitations, and we may, subject to obtainingrequired regulatory approvals, make a rescission offer to certain of such planparticipants.  Additionally, regulatoryauthorities may require us to pay fines or they may impose other sanctions onus, and we may face other claims by plan participants other than rescissionclaims.

 

If ourpossible rescission offer is made and accepted by plan participants holdingshares acquired under the Equity Compensation Plans or otherwise entitled torecover damages from us in respect of such shares they have sold we could beliable to make aggregate payments to these plan participants of up to $893,000in the aggregate, excluding interest and other possible fees, based upon sharesoutstanding under the Equity Compensation Plans as of January 31, 2005.

 

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

 

*Our stock price is volatile.*

 

The trading price for our common stock has beenvolatile, ranging from a low closing sales price of $1.09 in mid-February 2003,to a high closing sales price of $20.50 per share in October 2003, to acurrent sales price of $3.86 on April 12, 2005.  The share price has changed dramatically overshort periods.  We believe that thechanges in our stock price are affected by changing public perceptionsconcerning the strength of our intellectual property claims and other factorsbeyond our control.  Public perceptioncan change quickly and without any change or development in our underlyingbusiness or litigation position.  Aninvestment in our stock is subject to such volatility and, consequently, issubject to significant risk.

 

*Thereare risks associated with the potential exercise of our outstanding options.*

 

As of March 31,2005, we have issued and outstanding options to purchase up to approximately3,481,000 shares of common stock with an average exercise price of $4.18 pershare.  The existence of such rights toacquire common stock at fixed prices may prove a hindrance to our efforts toraise future equity and debt funding, and the exercise of such rights will dilutethe percentage ownership interest of our stockholders and may dilute the valueof their ownership.  The possible futuresale of shares issuable on the exercise of outstanding options could adverselyaffect the prevailing market price for our common stock.  Further, the holders of the outstandingrights may exercise them at a time when we would otherwise be able to obtainadditional equity capital on terms more favorable to us.

 

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*Theissuance of common shares to BayStar may have an adverse impact on the marketvalue of our stock and the existing holders of our common stock.*

 

Wepreviously had an effective registration statement on Form S-3 relating to thesale or distribution by BayStar as a selling stockholder of the 2,105,263shares of common stock issued to BayStar in connection with our repurchasecompleted in July 2004 of all Series A-1 shares previously held byBayStar.  When we failed to file our Form10-K in a timely fashion, we became ineligible to use Form S-3, ourregistration statement ceased to be effective and BayStar’s ability to resellshares pursuant to that registration statement terminated.  We are currently in the process of preparinga new registration statement for the resale of BayStar’s shares on FormS-1.  Upon that registration statementbeing declared effective by the SEC, BayStar will again be able to resell itsshares.  We will not receive any proceedsfrom the sales of the shares covered by such registration statement.  The shares that may be sold or distributedpursuant to such registration statement, upon being declared effective by theSEC, will represent approximately 8 percent of our issued and outstandingcommon stock.  The sale of the block ofstock to be covered by such registration statement, or even the possibility ofits sale, may adversely affect the trading market for our common stock andreduce the price available in that market.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Thefollowing includes updated information relating to certain of our materiallegal proceedings as previously reported in our Annual Report on Form 10-K forfiscal year 2004.

 

*IBM Corporation*

 

On or about March 6,2003, we filed a complaint against IBM Corporation (“IBM”).  This action is pending in the United StatesDistrict Court for the District of Utah, under the title The

 

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SCO Group, Inc. v. International Business MachinesCorporation, Civil No. 2:03CV0294.  Thisaction includes, among other things, our claim against IBM for breach ofcontract, copyright infringement, tortious interference, and unfair competitionrelating to IBM’s alleged use and distribution of information concerning theUNIX source code and derivative works in connection with its efforts to promotethe Linux operating system.  IBM hasresponded to our claims and made counterclaims against us.

 

Following a hearing on October 19,2004, on January 19, 2005, the United States Magistrate Judge overseeingthe case issued an order granting in part and denying in part discoveryapplications that we had made.  The Courtordered IBM to produce much of the information, including source code, revisioninformation, and programmer contribution information, that we had previouslyrequested.  The court also struck theAmended Scheduling Order and directed the parties to submit a proposed amendedscheduling order to the court, which both parties have done.

 

In response to theMagistrate Court’s Order, IBM filed, on February 11, 2005, a Motion forReconsideration of the portion of the Order that required IBM to produceprogrammer-contribution information for 3,000 people.  The parties have fully briefed this motion,but no date has been set for oral arguments.

 

IBM also filed, on March 9,2005,  a Motion for a 45-day Extension ofTime to Comply with the Court’s January 18 Order as it applies tomaterials that are not the subject of IBM’s above-referenced Motion forReconsideration.  On March 16, 2005,the Court granted the extension and entered an order requiring IBM to producethose materials by May 3, 2005.  Withrespect to the materials that are the subject of IBM’s Motion forReconsideration, the Court granted IBM’s request to stay its discoveryobligations until the Court rules on that motion.

 

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

 

Additional discoverymotions that we have filed are also pending before the Court.  On January 12, 2005, we filed our Motionto Compel IBM to produce IBM CEO Samuel J. Palmisano for Deposition.  The parties have fully briefed this motion,and the Court has scheduled oral arguments for April 21, 2005.  The parties have also now fully briefed our December 23,2004 Renewed Motion to Compel Discovery, which seeks to compel IBM’s compliancewith prior Court orders relating to IBM’s obligation to produce (1) alldocuments pertaining to Linux from the files of high-level IBM executives andboard members; and (2) to compel IBM to produce witnesses to testify on severaltopics in two deposition notices that we have served on IBM.  The Court has not set a hearing date for thismotion.

 

In addition to thematerials that have been publicly filed with the Court, certain information hasbeen filed under seal in accordance with the protective order entered in thecase.  On November 30, 2004, a thirdparty moved to intervene in the case for the purpose of challenging the sealingof certain documents filed with the Court. Additional groups have joined in that motion, which has been scheduledfor a hearing on April 26, 2005.

 

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We have also filed amotion for leave to file a third amended complaint in order to assert anadditional copyright claim against IBM in the case.  Argument on that motion has been scheduledfor April 21, 2005, but we have requested that the Court adjourn thatargument date to permit the Company to amend its complaint further bypotentially adding additional claims against IBM.  IBM has filed an opposition to our motion toadjourn the April 21 hearing.  Wecurrently anticipate we will assert those new claims in the near future.

 

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

 

Discovery is continuingin the case.

 

**ITEM 2.****                                                     CHANGESIN SECURITIES AND USE OF PROCEEDS**

 

**Recent Sales of Unregistered Securities**

 

As described elsewhere in this Form 10-Q, we haveissued shares and granted options under our Equity Compensation Planswithout complying 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 Equity Compensation Plansor recover damages if they no longer own the shares or hold unexercisedoptions, subject to applicable statutes of limitations.  Additionally, regulatory authorities mayrequire us to pay fines or impose other sanctions on us.  Although we are evaluating the possibleactions we may take in response to these securities law compliance issues, wemay, subject to obtaining required regulatory approvals, make a rescissionoffer to certain plan participants that hold unexercised options (inCalifornia, Georgia and possibly other states) or shares acquired under theEquity Compensation Plans or that otherwise are entitled to recover damagesfrom us in respect of such shares they have sold.

 

**ITEM 5.****                                                     OTHERINFORMATION**

 

**1.****                                      ExecutiveOfficer Equity Awards and Bonuses Paid for Fiscal Year 2005.**

 

On December 8, 2004, our board of directorsapproved the following compensation awards to the executive officers in theamounts identified in the table below:

 

**•**                  *Equity Awards.* The executive officers were awarded stock options to purchase shares ofour common stock pursuant to our 2004 Omnibus Equity Incentive Plan.  Each of the stock options, as provided in theExecutive Officer Stock Option Agreements dated as of December 8, 2004between each executive officer and us, has an exercise price of $4.85 per shareand will expire ten years from the date of grant.  The first 25 percent of the option sharesvest upon the first anniversary of the date of grant and the remaining optionshares vest over the following three years on a monthly basis so long as theexecutive officers remain in service with the Company.  However, option vesting will accelerate upona change in control of the Company and upon the declaration by our board ofdirectors of the payment of a dividend to the common stockholders of theCompany as a result of the Company entering into a cash settlement in ourlitigation with IBM.  This description ofthe Stock Option Agreements is subject to, and qualified in its entirety by,the Form of Executive Officer Stock Option Agreement attached to this Form 10-Qas Exhibit 10.3.

 

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**•**                  *Bonuses.* The executive officers received cash bonuses and commissions for theirservice during the fiscal year ended October 31, 2004.  The amounts of the awards were determinedbased upon the attainment of performance objectives by each executive officerrelating to (i) the operating results of our UNIX division, (ii) management ofthe SCO Litigation and (iii) other objectives related to simplifying ourcapital structure. 
| **Name**                                                                   | ** ** | **Number of Shares  Issuable Upon Exercise of  Granted Stock Options** | ** ** | **Amount of Cash  Bonus Paid** | ** **  |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|--------------------------------|-------------|
|                                                                       |       |                                                                   |       |                           |        |
| Darl C. McBride(2)  President and Chief Executive Officer                  |       | 100,000                                                                |       | $                              | 35,000      |   |
| Bert B. Young(2)  Chief Financial Officer                                  |       | 150,000                                                                |       | $                              | 30,000      |   |
| Chris Sontag(2)  Senior Vice President, Business Development               |       | 25,000                                                                 |       | $                              | 20,000      |   |
| Jeff Hunsaker(1)  Senior Vice President and General Manager, UNIX Division |       | 25,000                                                                 |       | $                              | 51,804      |   |
| Ryan E. Tibbitts(2)  General Counsel and Corporate Secretary               |       | 150,000                                                                |       | $                              | 50,000      |   |
| **TOTALS**                                                                 | ** ** | **450,000**                                                            | ** ** | **$**                          | **186,804** | ** ** |

 

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(1)                                  Mr. Hunsaker earned a total $133,981 inbonuses for his service in fiscal year 2004, of which $82,177 was paid duringfiscal year 2004 and the remaining $51,804 was paid in the first quarter offiscal year 2005.

(2)                                  Bonus amounts were for service in fiscal year2004 and paid in the first quarter of fiscal year 2005.

 

**2.****                                      TheSCO Group Employee Incentive Bonus Program for Fiscal Year 2005.**

 

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

 

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

 

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The potential maximum bonus amounts that may be earnedby all executive officers under the Bonus Program, if we exceed revenue andoperating performance targets by 150 percent and the executive officers satisfyall other personal objectives, are as follows:

 
| **Name**                                                                | ** ** | **Potential Annual Bonus  for Fiscal Year 2005** | ** **  |
|-------------------------------------------------------------------------|------------|--------------------------------------------------|-------------|
|                                                                    |       |                                             |        |
| Darl C. McBride  President and Chief Executive Officer                  |       | $                                                | 371,000     |   |
| Bert B. Young  Chief Financial Officer                                  |       | $                                                | 136,000     |   |
| Chris Sontag  Senior Vice President, Business Development               |       | $                                                | 128,000     |   |
| Jeff Hunsaker  Senior Vice President and General Manager, UNIX Division |       | $                                                | 128,000     |   |
| Ryan E. Tibbitts  General Counsel and Corporate Secretary               |       | $                                                | 116,000     |   |
| **TOTALS**                                                              | ** ** | **$**                                            | **879,000** | ** ** |

 

This description of the Bonus Program is subject to,and qualified in its entirety by, the The SCO Group Employee Incentive BonusProgram****for fiscal year 2005attached to this Form 10-Q as Exhibit 10.1.

 

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

 

(a)                                  Exhibits

 
| 3.1    |   | Amended and  Restated Certificate of Incorporation of Caldera International, Inc.  (incorporated by reference to Exhibit 3.1 to SCO’s Registration Statement on  Form 8-A12G/A (File No. 000-29911)).                                                  |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                        |
| 3.2    |   | Certificate of  Amendment to Amended and Restated Certificate of Incorporation regarding  consolidation of outstanding shares (incorporated by reference to Exhibit 3.2  to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).       |
|   |   |                                                                                                                                                                                                                                                        |
| 3.3    |   | Certificate of  Amendment to Amended and Restated Certificate of Incorporation regarding  change of name to The SCO Group, Inc. (incorporated by reference to Exhibit  3.3 to SCO’s Registration Statement on Form 8A12G/A (File No. 000-29911)).      |
|   |   |                                                                                                                                                                                                                                                        |
| 3.4    |   | Amended and  Restated Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s  Registration Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                        |
|   |   |                                                                                                                                                                                                                                                        |
| 3.5    |   | Certificate of  Designation for Series A-1 Convertible Preferred Stock (incorporated by  reference to Exhibit 4.1 to SCO’s Current Report on Form 8-K filed on  February 9, 2004 (File No. 000-29911)).                                           |
|   |   |                                                                                                                                                                                                                                                        |
| 3.6    |   | Certificate of  Correction correcting the Certificate of Designation for Series A-1  Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to  SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No.  000-29911)). |

 

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| 10.1   |   | The SCO Group  Employee Incentive Bonus Program for Fiscal Year 2005.                                                                                                                                                             |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                              |
| 10.2   |   | Summary of  Executive Compensation.                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                              |
| 10.3   |   | Form of  Executive Officer Stock Option Agreement.                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                              |
| 10.4   |   | Form of Change  of Control Agreement (incorporated by reference to Exhibit 99.1 to SCO’s  Current Report on Form 8-K filed on December 16, 2004 (File No.  000-29911)).                                                 |
|   |   |                                                                                                                                                                                                                              |
| 31.1   |   | Certification of  Darl C. McBride, President and Chief Executive Officer, pursuant to Rule  13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                            |
|   |   |                                                                                                                                                                                                                              |
| 31.2   |   | Certification of  Bert B. Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of the  Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                            |
|   |   |                                                                                                                                                                                                                              |
| 32.1   |   | Certification of  Darl C. McBride, President and Chief Executive Officer, pursuant to  Section 1350, Chapter 63 of Title 18, United States Code, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                                                                                              |
| 32.2   |   | Certification of  Bert B. Young, Chief Financial Officer, pursuant to Section 1350,  Chapter 63 of Title 18, United States Code, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                 |

 

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

 

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

 
| Date: April 14,  2005 | THE SCO GROUP,  INC. |
|----------------------------|----------------------|
|                       |                 |   |   |
|                       |                 | By: | /s/ Bert Young |   |
|                       |                 |   | Bert Young |
|                       |                 |   | Duly Authorized  Officer and  Chief Financial Officer  (Principal Financial and  Accounting Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                                |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                                             |
| 3.1                 |       | Amended and  Restated Certificate of Incorporation of Caldera International, Inc.  (incorporated by reference to Exhibit 3.1 to SCO’s Registration Statement on  Form 8-A12G/A (File No. 000-29911)).                                             |
|                |       |                                                                                                                                                                                                                                                   |
| 3.2                 |       | Certificate of  Amendment to Amended and Restated Certificate of Incorporation regarding  consolidation of outstanding shares (incorporated by reference to Exhibit 3.2  to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).  |
|                |       |                                                                                                                                                                                                                                                   |
| 3.3                 |       | Certificate of  Amendment to Amended and Restated Certificate of Incorporation regarding  change of name to The SCO Group, Inc. (incorporated by reference to Exhibit  3.3 to SCO’s Registration Statement on Form 8A12G/A (File No. 000-29911)). |
|                |       |                                                                                                                                                                                                                                                   |
| 3.4                 |       | Amended and  Restated Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s  Registration Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                   |
|                |       |                                                                                                                                                                                                                                                   |
| 10.1                |       | The SCO Group  Employee Incentive Bonus Program for Fiscal Year 2005.                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                   |
| 10.2                |       | Summary of  Executive Compensation.                                                                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                   |
| 10.3                |       | Form of  Executive Officer Stock Option Agreement.                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                   |
| 10.4                |       | Form of Change  of Control Agreement (incorporated by reference to Exhibit 99.1 to SCO’s Current  Report on Form 8-K filed on December 16, 2004 (File No. 000-29911)).                                                                       |
|                |       |                                                                                                                                                                                                                                                   |
| 31.1                |       | Certification of  Darl C. McBride, President and Chief Executive Officer, pursuant to Rule  13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                 |
|                |       |                                                                                                                                                                                                                                                   |
| 31.2                |       | Certification of  Bert Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of the  Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                    |
|                |       |                                                                                                                                                                                                                                                   |
| 32.1                |       | Certification of  Darl C. McBride, President and Chief Executive Officer, pursuant to Section 1350,  Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                      |
|                |       |                                                                                                                                                                                                                                                   |
| **32.2**            | ** ** | **Certification of  Bert Young, Chief Financial Officer, pursuant to Section 1350, Chapter  63 of Title 18, United States Code, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.**                                     |

 

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