**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,  2004**                                                                                                                                  |
|                                                                                                                                                                                  |   |   |
| **OR**                                                                                                                                                                                |
|                                                                                                                                                                                  |   |   |
| **o**                                                                                                                                                                                 |   | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                  |   |   |
| **For the transition period  from            to            ** |

 

**Commission file number 0-29911**

 

**THE SCO GROUP, INC.**

(Exact name of registrant as specified inits charter)

 

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

 

**355 South 520 West**

**Suite 100**

**Lindon, Utah 84042**

(Address of principal executive offices andzip code)

 

**(801) 765-4999**

(Registrant’s telephone number, includingarea code)

 

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

 

YES ýNO o

 

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

 

YES ý NO o

 

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

 

 

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**The SCO Group, Inc.**

 

**Table of Contents**

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

 

2

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

 

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(unaudited,in thousands)**

 
|                                                                                                                      |   | **January  31,  2004** |       | **October  31,  2003** |       |
|---------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|------------------------|------------|
|                                                                                                                      |   |                   |       |                   |       |
| **ASSETS**                                                                                                                |   |                   | ** ** |                   | ** ** |
|                                                                                                                      |   |                   |       |                   |       |
| CURRENT ASSETS:                                                                                                           |   |                   |       |                   |       |
| Cash and cash equivalents                                                                                                 |   | $                      | 57,945     |                   | $          | 64,428 |   |
| Restricted cash                                                                                                           |   | 550                    |       | 2,025                  |       |
| Available-for-sale securities                                                                                             |   | 6,762                  |       | 4,095                  |       |
| Accounts receivable, net of allowance for  doubtful accounts of $231 and $230, respectively                               |   | 9,151                  |       | 9,282                  |       |
| Other current assets                                                                                                      |   | 1,864                  |       | 2,450                  |       |
| Total current assets                                                                                                      |   | 76,272                 |       | 82,280                 |       |
|                                                                                                                      |   |                   |       |                   |       |
| PROPERTY AND EQUIPMENT:                                                                                                   |   |                   |       |                   |       |
| Computer and office equipment                                                                                             |   | 3,658                  |       | 3,482                  |       |
| Leasehold improvements                                                                                                    |   | 626                    |       | 608                    |       |
| Furniture and fixtures                                                                                                    |   | 206                    |       | 189                    |       |
|                                                                                                                      |   | 4,490                  |       | 4,279                  |       |
| Less accumulated depreciation and  amortization                                                                           |   | (3,439                 | )          | (3,131                 | )          |
| Net property and equipment                                                                                                |   | 1,051                  |       | 1,148                  |       |
|                                                                                                                      |   |                   |       |                   |       |
| OTHER ASSETS:                                                                                                             |   |                   |       |                   |       |
| Goodwill                                                                                                                  |   | 1,166                  |       | 1,166                  |       |
| Intangibles, net                                                                                                          |   | 8,415                  |       | 9,286                  |       |
| Other assets, net                                                                                                         |   | 1,311                  |       | 1,072                  |       |
| Total other assets                                                                                                        |   | 10,892                 |       | 11,524                 |       |
|                                                                                                                      |   |                   |       |                   |       |
| Total assets                                                                                                              |   | $                      | 88,215     |                   | $          | 94,952 |   |
|                                                                                                                      |   |                   |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                             |   |                   | ** ** |                   | ** ** |
|                                                                                                                      |   |                   |       |                   |       |
| CURRENT LIABILITIES:                                                                                                      |   |                   |       |                   |       |
| Accounts payable                                                                                                          |   | $                      | 1,418      |                   | $          | 1,978 |   |
| Royalty payable to Novell, Inc.                                                                                           |   | 550                    |       | 2,025                  |       |
| Accrued compensation to law firms                                                                                         |   | 7,956                  |       | 10,556                 |       |
| Accrued payroll and benefits                                                                                              |   | 3,583                  |       | 4,752                  |       |
| Accrued liabilities                                                                                                       |   | 5,609                  |       | 3,754                  |       |
| Derivative related to redeemable  convertible preferred stock                                                             |   | 11,600                 |       | 15,224                 |       |
| Deferred revenue                                                                                                          |   | 6,952                  |       | 5,501                  |       |
| Other royalties payable                                                                                                   |   | 308                    |       | 523                    |       |
| Taxes payable                                                                                                             |   | 966                    |       | 799                    |       |
| Total current liabilities                                                                                                 |   | 38,942                 |       | 45,112                 |       |
|                                                                                                                      |   |                   |       |                   |       |
| LONG-TERM LIABILITIES                                                                                                     |   | 578                    |       | 508                    |       |
|                                                                                                                      |   |                   |       |                   |       |
| MINORITY INTEREST                                                                                                         |   | 145                    |       | 145                    |       |
|                                                                                                                      |   |                   |       |                   |       |
| SERIES A REDEEMABLE CONVERTIBLE PREFERRED  STOCK,   $0.001 par value, 50 and 50 shares outstanding, respectively (Note 5) |   | 29,671                 |       | 29,671                 |       |
|                                                                                                                      |   |                   |       |                   |       |
|                                                                                                                      |   |                   |       |                   |       |
| COMMITMENTS AND CONTINGENCIES (Note 6)                                                                                    |   |                   |       |                   |       |
|                                                                                                                      |   |                   |       |                   |       |
| STOCKHOLDERS’ EQUITY:                                                                                                |   |                   |       |                   |       |
| Preferred stock, $0.001 par value; 5,000  shares authorized,                                                              |   | —                 |       | —                 |       |
| Common stock, $0.001 par value; 45,000  shares authorized, 14,340 and 13,824 shares outstanding, respectively             |   | 14                     |       | 14                     |       |
| Additional paid-in capital                                                                                                |   | 219,449                |       | 218,690                |       |
| Warrants outstanding                                                                                                      |   | 1,099                  |       | 1,099                  |       |
| Deferred compensation                                                                                                     |   | (237                   | )          | (347                   | )          |
| Accumulated other comprehensive income                                                                                    |   | 917                    |       | 926                    |       |
| Accumulated deficit                                                                                                       |   | (202,363               | )          | (200,866               | )          |
| Total stockholders’ equity                                                                                           |   | 18,879                 |       | 19,516                 |       |
|                                                                                                                      |   |                   |       |                   |       |
| Total liabilities and stockholders’ equity                                                                           |   | $                      | 88,215     |                   | $          | 94,952 |   |

 

See notes to condensed consolidated financial statements.

 

3

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS****AND COMPREHENSIVE LOSS**

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

 
|                                                                                                                                         |   | **Three Months Ended January 31,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                                                                                         |   | **2004**                           |   | **2003** |   |
|                                                                                                                                         |   |                               |   |   |   |
| REVENUE:                                                                                                                                     |   |                               |   |   |   |
| Products                                                                                                                                     |   | $                                  | 9,712  |   | $ | 11,090 |   |
| SCOsource licensing                                                                                                                          |   | 20                                 |   | — |   |
| Services                                                                                                                                     |   | 1,660                              |   | 2,450 |   |
| Total revenue                                                                                                                                |   | 11,392                             |   | 13,540 |   |
|                                                                                                                                         |   |                               |   |   |   |
| COST OF REVENUE:                                                                                                                             |   |                               |   |   |   |
| Software and related  products Products                                                                                                      |   | 888                                |   | 1,186 |   |
| SCOsource licensing                                                                                                                          |   | 3,440                              |   | — |   |
| Services                                                                                                                                     |   | 1,322                              |   | 1,692 |   |
| Total cost of revenue  Total cost of revenue                                                                                                 |   | 5,650                              |   | 2,878 |   |
|                                                                                                                                         |   |                               |   |   |   |
| GROSS MARGIN                                                                                                                                 |   | 5,742                              |   | 10,662 |   |
|                                                                                                                                         |   |                               |   |   |   |
| OPERATING EXPENSES:                                                                                                                          |   |                               |   |   |   |
| Sales and marketing  (exclusive of non-cash Sales and marketing (exclusive of stock-based  compensation of  $18 and $34,  respectively) |   | 5,021                              |   | 6,440 |   |
| Research and development  Research and development (exclusive of stock-based compensation of $12 and  $23, respectively)                     |   | 2,707                              |   | 2,650 |   |
| General and administrative  General and administrative (exclusive of stock-based compensation of $172 and  $155, respectively)               |   | 2,194                              |   | 1,650 |   |
| Restructuring charges  (reversals)                                                                                                           |   | —                             |   | (252 | ) |
| Amortization of  intangibles                                                                                                                 |   | 787                                |   | 700 |   |
| Stock-based compensation                                                                                                                     |   | 202                                |   | 212 |   |
| Total operating expenses  Total operating expenses                                                                                           |   | 10,911                             |   | 11,400 |   |
|                                                                                                                                         |   |                               |   |   |   |
| LOSS FROM OPERATIONS                                                                                                                         |   | (5,169                             | )      | (738 | ) |
|                                                                                                                                         |   |                               |   |   |   |
| EQUITY IN INCOME (LOSSES)  OF AFFILIATES                                                                                                     |   | 37                                 |   | (25 | ) |
|                                                                                                                                         |   |                               |   |   |   |
| OTHER INCOME (EXPENSE):                                                                                                                      |   |                               |   |   |   |
| Interest income                                                                                                                              |   | 270                                |   | 39 |   |
| Change in fair value of  derivative (Note 5)                                                                                                 |   | 3,624                              |   | — |   |
| Other income (expense),  net                                                                                                                 |   | (131                               | )      | 5 |   |
| Total other income, net                                                                                                                      |   | 3,763                              |   | 44 |   |
|                                                                                                                                         |   |                               |   |   |   |
| LOSS BEFORE INCOME TAXES                                                                                                                     |   | (1,369                             | )      | (719 | ) |
|                                                                                                                                         |   |                               |   |   |   |
| PROVISION FOR INCOME TAXES                                                                                                                   |   | (128                               | )      | (5 | ) |
|                                                                                                                                         |   |                               |   |   |   |
| NET LOSS                                                                                                                                     |   | (1,497                             | )      | (724 | ) |
|                                                                                                                                         |   |                               |   |   |   |
| DIVIDENDS ON SERIES A  REDEEMABLE CONVERTIBLE PREFERRED STOCK                                                                                |   | (756                               | )      | — |   |
|                                                                                                                                         |   |                               |   |   |   |
| NET LOSS APPLICABLE TO  COMMON STOCKHOLDERS                                                                                                  |   | $                                  | (2,253 | ) | $ | (724 | ) |
|                                                                                                                                         |   |                               |   |   |   |
| BASIC AND DILUTED NET LOSS  PER COMMON SHARE                                                                                                 |   | $                                  | (0.16  | ) | $ | (0.06 | ) |
|                                                                                                                                         |   |                               |   |   |   |
| WEIGHTED AVERAGE BASIC AND  DILUTED COMMON SHARES OUTSTANDING                                                                                |   | 13,824                             |   | 11,244 |   |
|                                                                                                                                         |   |                               |   |   |   |
| OTHER COMPREHENSIVE LOSS                                                                                                                     |   |                               |   |   |   |
| Net loss                                                                                                                                     |   | $                                  | (1,497 | ) | $ | (724 | ) |
| Unrealized loss on  available-for-sale securities                                                                                            |   | (19                                | )      | — |   |
| Foreign currency  translation adjustment                                                                                                     |   | 10                                 |   | 157 |   |
| COMPREHENSIVE LOSS                                                                                                                           |   | $                                  | (1,506 | ) | $ | (567 | ) |

 

See notes to condensed consolidated financial statements.

 

4

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited,in thousands)**

 
|                                                                               |   | **Three Months Ended January 31,** |   |
|------------------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                               |   | **2004**                           |   | **2003** |   |
|                                                                               |   |                               |   |   | * * |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                             |   |                               |   |   |   |
| Net loss                                                                           |   | $                                  | (1,497 | ) | $ | (724 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities:       |   |                               |   |   |   |
| Change in fair value of  derivative                                                |   | (3,624                             | )      | — |   |
| Amortization of  intangibles (including $84 and $85 classified as cost of revenue) |   | 871                                |   | 785 |   |
| Depreciation and other  amortization                                               |   | 252                                |   | 341 |   |
| Stock-based compensation                                                           |   | 202                                |   | 212 |   |
| Equity in (income) losses  of affiliates                                           |   | (37                                | )      | 25 |   |
| Changes in operating  assets and liabilities                                       |   |                               |   |   |   |
| Accounts receivable, net                                                           |   | 131                                |   | (867 | ) |
| Other current assets                                                               |   | 586                                |   | 1,906 |   |
| Other assets                                                                       |   | (202                               | )      | (94 | ) |
| Accounts payable                                                                   |   | (560                               | )      | (416 | ) |
| Accrued payroll and  benefits                                                      |   | (1,169                             | )      | (1,046 | ) |
| Accrued compensation to  law firms                                                 |   | (2,600                             | )      | — |   |
| Accrued liabilities                                                                |   | 1,855                              |   | (1,022 | ) |
| Deferred revenue                                                                   |   | 1,451                              |   | (254 | ) |
| Other royalties payable                                                            |   | (215                               | )      | (68 | ) |
| Taxes payable                                                                      |   | 167                                |   | (191 | ) |
| Long-term liabilities                                                              |   | 70                                 |   | (195 | ) |
| Net cash used in operating  activities                                             |   | (4,319                             | )      | (1,608 | ) |
|                                                                               |   |                               |   |   |   |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                             |   |                               |   |   |   |
| Purchase of property and  equipment                                                |   | (131                               | )      | (17 | ) |
| Purchase of  available-for-sale securities                                         |   | (4,035                             | )      | — |   |
| Proceeds from  available-for-sale securities                                       |   | 1,368                              |   | — |   |
| Investment in  non-marketable securities                                           |   | —                             |   | (350 | ) |
| Net cash used in investing  activities                                             |   | (2,798                             | )      | (367 | ) |
|                                                                               |   |                               |   |   |   |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                             |   |                               |   |   |   |
| Proceeds from sale of  common stock through ESP program                            |   | 370                                |   | 57 |   |
| Proceeds from exercise of  common stock options                                    |   | 297                                |   | 124 |   |
| Net cash provided by  financing activities                                         |   | 667                                |   | 181 |   |
|                                                                               |   |                               |   |   |   |
| NET DECREASE IN CASH AND  CASH EQUIVALENTS                                         |   | (6,450                             | )      | (1,794 | ) |
| EFFECT OF FOREIGN EXCHANGE  RATES ON CASH                                          |   | (33                                | )      | 147 |   |
| CASH AND CASH EQUIVALENTS,  beginning of period                                    |   | 64,428                             |   | 6,589 |   |
| CASH AND CASH EQUIVALENTS,  end of period                                          |   | $                                  | 57,945 |   | $ | 4,942 |   |
|                                                                               |   |                               |   |   |   |
| SUPPLEMENTAL DISCLOSURE OF  CASH FLOW INFORMATION:                                 |   |                               |   |   |   |
|                                                                               |   |                               |   |   |   |
| Cash paid for taxes                                                                |   | $                                  | 67     |   | $ | 129 |   |

 

See notes to condensed consolidated financial statements.

 

5

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

 

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

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

## ** **

The Companywas originally incorporated as Caldera Systems, Inc. (“Caldera Systems”), aUtah corporation, on August 21, 1998, and reincorporated as a Delawarecorporation on March 6, 2000.

 

On May 7, 2001, CalderaInternational, Inc. (“Caldera”) was formed as a holding company to own CalderaSystems and to acquire substantially all of the assets, liabilities andoperations of the server and professional services groups of The Santa CruzOperation, now known as Tarantella, Inc., pursuant to an Agreement and Plan ofReorganization (the “Reorganization Agreement”), dated as of August 1, 2000, asamended.  Under the ReorganizationAgreement, Caldera acquired the tangible and intangible assets used in theserver and professional services groups, including all of the capital stock ofcertain of The Santa Cruz Operation’s subsidiaries.  In connection with the formation of Caldera, Caldera Systems becamea wholly-owned subsidiary of Caldera. All shares of Caldera Systems’ common stock, as well as options topurchase shares of Caldera Systems’ common stock, were converted into the samenumber of shares of common stock of Caldera and options to purchase shares ofcommon stock of Caldera.

 

The acquired operations fromThe Santa Cruz Operation developed and marketed server software related tonetworked business computing and were one of the leading providers of UNIXserver operating systems.  In addition,these operations provided professional services related to implementing andmaintaining UNIX system software products. The acquisition provided Caldera with international offices and adistribution channel with resellers throughout the world.  Subsequent to this acquisition, the Companyhas primarily sold UNIX based products and services.

 

On May 16, 2003, Caldera’sstockholders approved an amendment to Caldera’s certificate of incorporationthat changed Caldera’s name to The SCO Group, Inc. (the “Company”).

 

The Company’s businessfocuses on marketing reliable, cost-effective UNIX software products andrelated services for the small-to-medium sized business market.  In January 2003, the Company established itsSCOsource division and launched its first of several SCOsource initiatives toreview and enforce its intellectual property surrounding the UNIX operatingsystem. The Company acquired the intellectual property rights surrounding UNIXand UNIX System V source code from The Santa Cruz Operation.

 

**(2)   SIGNIFICANT ACCOUNTING 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 statements

 

6

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prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to SEC rules and regulations, althoughthe Company believes that the following disclosures, when read in conjunctionwith the audited annual financial statements and the notes thereto included inthe Company’s most recent annual report on Form 10-K, are adequate to make theinformation presented not misleading.

 

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

### ** **

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period.  Actual results could differ from these estimates.  The Company’s critical accounting policiesand estimates, as discussed in the Company’s most recent annual report on Form10-K, include, among others, revenue recognition, allowances for doubtfulaccounts receivable, determination of fair value of the derivative associatedwith the Company’s previously issued shares of redeemable Series A ConvertiblePreferred Stock, impairment of long-lived assets, and valuation allowancesagainst deferred income tax assets.

 

### **Revenue Recognition**

### ** **

The Company recognizes revenue in accordance withStatement of Position (“SOP”) 97-2, as modified by SOP 98-9 and StaffAccounting Bulletin (“SAB”) No. 104. Revenue recognition in accordance with these pronouncements can becomplex due to the nature and variability of the Company’s salestransactions.  The Company’s revenue isprimarily from three sources: (i) product license revenue, primarily fromproduct sales to resellers and end users, and royalty revenue from productsales by source code original equipment manufacturers (“OEMs”); (ii) serviceand support revenue, primarily from providing support and education 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 and determinable, collection ofthe resulting receivable is probable and product returns are reasonablyestimable, except for sales to distributors, which are recognized upon sale bythe distributor to resellers or end users.

 

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

 

The Company recognizes product revenue from OEM’s uponreceipt of sales-out royalty reports and recognizes revenue from maintenancefees for ongoing customer support ratably over the period of the maintenancecontract.  Payments for maintenance feesare generally made in advance and are non-refundable.  Revenue from education and consulting services is recognized asthe related services are performed.

 

7

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The Company’s SCOsource licensing revenue to date hasbeen generated from license agreements to utilize the Company’s UNIX source codeas well as from intellectual property compliance licenses.  The Company recognizes revenue fromSCOsource licensing agreements when a signed contract exists, the fee is fixedand determinable, collection of the receivable is probable and delivery has occurred.  If the payment terms extend beyond theCompany’s normal payment terms, revenue is recognized as the payments arereceived.

 

**Hedging of Foreign Currency Transactions**

 

The Company utilizes foreign currency forward exchangecontracts to hedge foreign currency market exposures of underlying assets andliabilities.  The Company does not useforward exchange contracts for speculative or trading purposes.  The Company’s accounting policies for theseinstruments are based on the Company’s designation of such instruments ashedging transactions.  The criteria theCompany uses for designating an instrument as a hedge include the instrument’seffectiveness in risk reduction and one-to-one matching of forward exchange contractsto underlying transactions.  Gains andlosses on currency forward contracts that are designated and effective ashedges of firm commitments are deferred and recognized in income in the sameperiod that the underlying transactions are settled.  Gains and losses on currency forward contracts that aredesignated and effective as hedges of existing transactions are recognized inincome in the same period as losses and gains on the underlying transactionsare recognized and generally offset. Gains and losses on any instruments not meeting the above criteria arerecognized in income in the current period. As of January 31, 2004, the Company had one foreign exchange contractwith a maturity of approximately 30 days to sell an aggregate of 650,000 UnitedKingdom pounds for approximately $1,170,000 U.S. dollars.  As of January 31, 2004, theCompany had no outstanding instruments accounted for as hedges.

 

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

 

The Company considers all highly liquid debtinstruments purchased with original maturities of three or fewer months to becash equivalents.  Cash and cashequivalents were approximately $57,945,000 as of January 31, 2004, whichprimarily consisted of investments in money market funds and commercial paper.

 

The following table showsthe cost, realized gain or loss and fair market value of the Company’s cashequivalents and available-for-sale securities as of January 31, 2004 (inthousands):

 

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

 

 

 

8

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Available-for-sale securities as of January 31, 2004 included government agencies,corporate notes, money market funds, and corporate debt.  Available-for-sale securities are recordedat fair market value, based on quoted market prices, and unrealized gains andlosses are 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.  As of January31, 2004, available-for-sale securities consisted of the following maturities(in thousands):

 

|               |   | **2004** |   |
|--------------------|--------|----------|--------|
| Maturity date      |   |     |   |
| 3 – 6 months  |   | $        | — |   |
| 6 – 12 months |   | 1,446    |   |
| > 12 months     |   | 5,316    |   |
| Total              |   | $        | 6,762  |   |

 

**NetIncome (Loss) per Common Share**

 

Basic net income (loss) per common share (“Basic EPS”)is computed by dividing net income (loss) by the weighted average number ofcommon shares outstanding.  Diluted netincome (loss) per common share (“Diluted EPS”) is computed by dividing netincome (loss) by the sum of the weighted average number of common sharesoutstanding and the dilutive potential common share equivalents thenoutstanding.  Potential common shareequivalents consist of the weighted average of shares issuable upon theexercise of outstanding stock options, restricted stock awards, issued sharesof redeemable Series A Convertible Preferred Stock and warrants to acquirecommon stock.

 

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

 

|                                             |   | **Three Months Ended January 31,** |   |
|--------------------------------------------------|--------|------------------------------------|--------|
|                                             |   | **2004**                           |   | **2003** |   |
|                                             |   |                               |   |   |   |
| Numerator:                                       |   |                               |   |   |   |
| Net loss applicable to common stockholders       |   | $                                  | (2,253 | ) | $ | (724 | ) |
|                                             |   |                               |   |   |   |
| Denominator:                                     |   |                               |   |   |   |
| Weighted average common shares outstanding       |   | 13,824                             |   | 11,244 |   |
|                                             |   |                               |   |   |   |
| Basic and diluted EPS                            |   | $                                  | (0.16  | ) | $ | (0.06 | ) |
|                                             |   |                               |   |   |   |
| Excluded anti-dilutive common share  equivalents |   | 6,548                              |   | 3,986 |   |

 

**ProForma Fair Value of Stock-based Compensation**

 

The Company accounts for stock options issued todirectors, officers and employees under Accounting Principles Board (“APB”) No.25.  Under APB No. 25, compensationexpense is recognized if an option’s exercise price on the measurement date isbelow the fair market value of the Company’s common stock.

 

Statements of Financial Accounting Standards (“SFAS”)No. 148, “Accounting for Stock-Based Compensation,” requires pro formainformation regarding net income (loss)as if the Company had accounted for its stock options granted under the fairvalue method.  The fair value for theCompany’s stock options is estimated on the date of grant using theBlack-Scholes option-pricing model.

 

9

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

 

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

 

Forpurposes of the pro forma disclosure, the estimated fair value of the stockoptions, restricted stock awards and ESPP shares are amortized over the vestingperiod of the award.  The following isthe pro forma disclosure and the related impact on net loss and the net lossper diluted common share for the three months ended January 31, 2004 and 2003(in thousands, except per share amounts):****

 

|                                                                  |   | **Three Months Ended January 31,** |   |
|-----------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                  |   | **2004**                           |   | **2003** |   |
|                                                                  |   |                               |   |   |   |
| Net loss applicable to common stockholders:                           |   |                               |   |   |   |
| As reported                                                           |   | $                                  | (2,253 | ) | $ | (724 | ) |
| Stock-based compensation as reported                                  |   | 202                                |   | 212 |   |
| Stock-based compensation under fair value  method                     |   | (503                               | )      | (678 | ) |
| Pro forma net loss                                                    |   | $                                  | (2,554 | ) | $ | (1,190 | ) |
|                                                                  |   |                               |   |   |   |
| Net loss applicable to common stockholders  per diluted common share: |   |                               |   |   |   |
| As reported                                                           |   | $                                  | (0.16  | ) | $ | (0.06 | ) |
| Pro forma                                                             |   | $                                  | (0.18  | ) | $ | (0.11 | ) |

 

**(3)   INTANGIBLEASSETS**

 

In July 2001, the Financial Accounting Standards Boardissued SFAS No. 142, “Goodwill and Other Intangible Assets.”  Under SFAS No. 142, goodwill and otherintangible assets with indefinite lives are no longer amortized, but rather areassessed annually for impairment.  TheCompany adopted SFAS No. 142 on November 1, 2001, the beginning of fiscal year2002.  All of the Company’s identifiableintangible assets are deemed to have finite lives and are amortized over theirremaining useful lives.

 

Upon adoption of SFAS 142, the Company reassessed theuseful lives of its intangible assets. The following table summarizes the components of amortized intangibleassets and their useful lives as of January 31, 2004 (in thousands):

 

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

 

The carrying amount of goodwill as of January 31, 2004was $1,166,000 related to the Company’s acquisition of substantially all theassets of Vultus, Inc., a web services business, in fiscal year 2003.  The Company performed an impairment analysisas of January 31, 2004 in

 

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accordance with SFAS No.142, and determined that the goodwill reported in the accompanying condensedconsolidated balance sheets was not impaired. However, events and circumstances may change in future periods that mayrequire to the Company to record an impairment charge related to the goodwill.

 

**(4)   RESTRUCTURINGPLANS**

 

The Company’s board of directors has adoptedrestructuring plans to reduce facilities and personnel.  These restructuring plans have resulted inthe Company recording restructuring accruals for the costs associated with thereduction in facilities and for severance costs of affected employees.  There were no restructuring activitiesundertaken during the three months ended January 31, 2004.  The following table summarizes the activityrelated to the restructuring accruals during the three months ended January 31,2004 (in thousands): 

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

 

The remaining restructuring accrual relates to costsassociated with one facility that has future lease payments extending throughJune 2005.

 

**(5)   REDEEMABLESERIES A CONVERTIBLE PREFERRED STOCK**

 

On October 16, 2003, the Company issued 50,000 sharesof its redeemable Series A Convertible Preferred Stock (the “Series A”) for$1,000 per share.  The net proceeds fromthe sale of the Series A were $47,740,000. The value of the Series A is classified outside of permanent equitybecause of certain redemption features that are outside the control of theCompany.  ** **As described in Note10, on February 5, 2004, all outstanding Series A shares were exchanged forshares of the Company’s redeemable Series A-1 Convertible Preferred Stock and,as a result, no Series A shares remain outstanding as of February 5, 2004.

 

The terms of the Series A include a number ofredemption provisions that represent a derivative financial instrument underSFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities.”  The Company determinedthat the conversion feature to allow the holders of the Series A to acquirecommon shares was an embedded derivative that does not qualify as a scopeexemption under the provisions of EITF 00-19, “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in a Company’s OwnStock.”  This required the Company torecord at fair value and mark-to-market the fair value of the derivative.  Changes in the fair value of the derivativeare recorded in the Company’s statement of operations.  As of October 16, 2003, the Company, throughthe assistance of an independent valuation firm, determined the initial fairvalue of the derivative was $18,069,000. As of October 31, 2003, the fair value of the derivative was $15,224,000and the decrease in fair value of $2,845,000 was recorded as other income inthe statement of operations for fiscal year 2003.

 

As of January 31, 2004, the fair value of thederivative was $11,600,000, and the decrease in fair value of $3,624,000 wasrecorded as other income in the statement of operations for three months endedJanuary 31, 2004.  Assumptions used tovalue the derivative as of January 31, 2004 included a term of three years,fair value of common stock of $14.37 and an interest rate for similarsecurities of 15 percent.

 

Dividends will be paid after the first anniversary ofthe closing and will be paid quarterly at a rate of 8 percent per annum,subject to annual increases of 2 percent per annum, not to exceed

 

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12 percent perannum.  The Company has the option ofpaying dividends in cash or shares of the Series A, subject to certainlimitations.  Because dividends are notpayable during the first year the Series A is outstanding, the Company hasaccrued dividends of $756,000 for three months ended January 31, 2004, whichreduced earnings to common stockholders. These dividends are in addition to $123,000 in accrued dividendsrecorded in fiscal year 2003.

 

Subject to certain limitations, each holder of theSeries A will have the right to convert, at the option of the holder, at anytime, into shares of the Company’s common stock at a stated conversion price of$16.93 per share, subject to stock splits, stock dividends or otheroccurrences.  The Company has theability to force conversion of the Series A at any time the Company’s commonstock price exceeds 150 percent of the then prevailing conversion price pershare for 20 consecutive trading days, provided the Company satisfies certainother requirements.

 

The Company was required to file a registrationstatement on Form S-3 covering the resale of the shares of common stockissuable upon conversion of the Series A. This registration statement was declared effective by the Securities andExchange Commission on February 25, 2004.

 

**(6)   COMMITMENTS AND CONTINGENCIES**

 

**Litigation**

 

*IBM, Corporation*

 

On or aboutMarch 6, 2003, the Company filed a complaint against IBM Corporation(“IBM”).  The action is currentlypending in the United States District Court for the District of Utah.  The complaint includes claims for breach ofcontract, misappropriation of trade secrets, tortious interference, and unfaircompetition.  The complaint also allegesthat IBM obtained information concerning the UNIX source code and derivativeworks from the Company and inappropriately used and distributed that informationin connection with its efforts to promote the Linux operating system.  As a result of IBM’s breach of contract andunfair competition and the marketplace injury sustained by the Company, it isrequesting damages in an amount to be proven at trial, but no less than $1billion, together with additional damages through and after the time oftrial.  On or about June 13, 2003, theCompany delivered to IBM a notice of termination of IBM’s UNIX licenseagreement with the Company, which license underlies IBM’s AIX software.

 

On or aboutJune 16, 2003, the Company filed an amended complaint in the IBM case.  The amended complaint essentially restatesand realleges the allegations of the original complaint and expands on thoseclaims.  Most importantly, the amendedcomplaint raises new allegations regarding IBM’s actions and breaches throughthe actions of Sequent Computer Systems, Inc. (“Sequent”), which IBMacquired.  The Company alleges that theSequent agreement was breached in several ways similar to those set forth aboveand it seeks damages flowing from those breaches.  The Company also seeks injunctive relief on several of itsclaims.

 

IBM has filed a response and counterclaim to thecomplaint, including a demand for a jury trial.  The Company has filed an answer to the IBM counterclaim denyingthe claims and asserting affirmative defenses. In its counterclaim, as amended on September 25, 2003, IBM asserts thatthe Company does not have the right to terminate IBM’s UNIX license or assertclaims based on the Company’s ownership of UNIX intellectual property againstIBM or others in the Linux community. In addition, IBM asserts that the Company has breached the GNU GeneralPublic License and has infringed certain patents held by IBM.  IBM’s counterclaims include claims forbreach of contract, violation of the Lanham Act, unfair competition,intentional interference with prospective economic relations, unfair anddeceptive trade practices, breach of

 

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the GNU general public license and patent infringement.  Discovery is ongoing in the case.  The Company intends to vigorously defendthese counterclaims.

 

On February 4, 2004, the Company filed a motion forleave to file amended pleadings in the case proposing to amend its complaintagainst IBM and to modify its affirmative defenses against IBM’scounterclaims.  On February 25, 2004,the court granted the Company’s motion for leave.  The second amended complaint, which was filed on February 27,2004, alleges nine causes of action that are similar to those set forth above,adds a new claim for copyright infringement and removes the claim formisappropriation of trade secrets.  IBMhas not yet responded to the second amended complaint.

 

*RedHat, Inc.*

 

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

 

On or about September 15, 2003, the Company filed amotion to dismiss the Red Hat complaint. The motion to dismiss asserts that Red Hat lacks standing and that nocase or controversy exists with respect to the claims seeking a declaratoryjudgment of non-infringement.  Themotion to dismiss further asserts that Red Hat’s claims under the Lanham Actand related state laws are barred by the First Amendment to the U.S.Constitution and the common law privilege of judicial immunity.  Red Hat has filed an opposition to theCompany’s motion to dismiss, but the court has not ruled on the motion.  The Company intends to vigorously defendthis action.

 

*Novell,Inc.*

 

On or about January 20, 2004, the Company broughtsuit against Novell, Inc. for slander of title seeking relief for Novell’salleged bad faith efforts to interfere with the Company’s copyrights related toits UNIX source code and derivative works and its UnixWare product.  In the lawsuit, the Company requestedpreliminary and permanent injunctive relief as well as damages.  The injunction would require Novell toassign to the Company all copyrights that it believes Novell has wrongfullyregistered, prevent Novell from representing any ownership interest in thosecopyrights and require Novell to retract or withdraw all representations it hasmade regarding its purported ownership of those copyrights.  Novell has not yet answered the Company’scomplaint but has filed with the United States District Court for the Districtof Utah a notice removing the case to such federal court and a motion with theThird Judicial District Court in Salt Lake County, Utah to transfer the venueof the case from such court to the Fourth Judicial District Court in UtahCounty, Utah.  Neither court has ruledon these actions.   Novell also filed amotion to dismiss the Company’s complaint claiming it never transferred thecopyrights to The Santa Cruz Operation. The Company has filed a response to Novell’s motion to dismiss and hasalso filed a motion to remand the case back to the state court.  The court has not ruled on thesemotions.  The Company plans tovigorously pursue its claims against Novell.

 

*IPOMatter*

 

The Company isan issuer defendant in a series of class action lawsuits involving over 300issuers that have been consolidated under one action.  The plaintiffs, the issuers and the insurance companies havenegotiated a Memorandum of Understanding (“MOU”) with the intent of

 

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

 

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

 

*Other Matters*

 

In April 2003,a former Indian distributor of the Company filed a claim in India, requestingsummary judgment for payment of $1,428,000, and an order that the Company tradein India only through the distributor until the claim is paid. The distributorclaims that the Company is responsible to repurchase certain software productsand to reimburse the distributor for certain other operating costs.  Management does not believe that the Companyis responsible to reimburse the distributor for any operating costs and alsobelieves that the return rights related to any remaining inventory havelapsed.  Management has engaged localcounsel who has advised that it is likely that the current claims will fail,but that the distributor will continue to pursue its claims either in theIndian courts or in the U.S. courts. Discovery has commenced and initial hearings have been held and areongoing.  The Company intends tovigorously defend this action.

 

Pursuit anddefense of the above-mentioned matters will be costly, and management expectsthe costs for legal fees and related expenses may be substantial.  The ultimate outcome or potential effect ofthe Company’s results of operations or financial position as a result of the above-mentionedmatters is not currently known or determinable.

 

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

 

**Arrangement with Law Firms**

 

On or about February 26, 2003, the Company enteredinto an arrangement with Boies, Schiller & Flexner LLP and other firms toinvestigate and review the Company’s UNIX intellectual property rights.  This arrangement was later modified onNovember 17, 2003 and December 8, 2003. The engagement with the law firms now includes the defense work relatedto counter suits and other retaliatory actions against the Company and lawsuitsagainst end users violating the Company’s intellectual property and contractualrights.  The law firms are also representingthe Company in its lawsuits against IBM and Novell and in the end user lawsuitsdescribed below in Note 10.

 

In addition to receiving fees at reduced hourly rates,the Company’s agreement with the law firms provides that the law firms willreceive a contingency fee of 20 percent of the proceeds from specified eventsrelated to the protection of the Company’s intellectual property rights.  These events may include settlements,judgments, licensing fees, subject to certain exceptions, and a sale of theCompany during the pendancy of litigation or through settlement, subject to

 

14

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agreed upon credits foramounts received as discounted hourly fees and unused retainer fees.  Additionally, the Company’s agreement withthe law firms may also be construed to include contingency fee payments inconnection with the Company’s issuance of equity securities.  Future payments payable to the law firmsunder this arrangement may be significant.

 

**(7)   STOCKHOLDERS’ EQUITY**

 

**Stock-BasedCompensation**

 

The following table details the components ofstock-based compensation for the three months ended January 31, 2004 and 2003(in thousands):

 

|                                     |   | **Three Months Ended January 31,** |   |
|------------------------------------------|--------|------------------------------------|--------|
|                                     |   | **2004**                           |   | **2003** |   |
|                                     |   |                               |   |   |   |
| Amortization of stock-based compensation |   | $                                  | 110    |   | $ | 156 |   |
| Options and shares for services          |   | —                             |   | 56 |   |
| Modifications to options                 |   | 92                                 |   | — |   |
| Total                                    |   | $                                  | 202    |   | $ | 212 |   |

 

During the three months ended January 31, 2004, theCompany granted options to purchase 49,000 shares of common stock with anaverage exercise price of $16.08 per share. None of these stock options was granted with an exercise price below thequoted market price on the date of grant. During the three months ended January 31, 2004, options to purchaseapproximately 175,000 shares of common stock were exercised with an averageexercise price of $1.69 per share.  Asof January 31, 2004, there were approximately 3,505,000 stock optionsoutstanding with a weighted average exercise price of $3.98 per share.

 

During the quarter ended January 31, 2004, the Companymodified an option grant to one of its board members.  The Company recognized compensation expense of approximately$92,000 related to the modification of this option.

 

**Employee Stock Purchase Plan**

 

The 2000 Employee Stock Purchase Plan, as amended, wasadopted by the board of directors on February 15, 2000 and was approved by thestockholders on March 1, 2000.  The planis designed to allow eligible employees of the Company and its participatingsubsidiaries to purchase shares of the Company’s common stock, at semi-annualintervals, through periodic payroll deductions.  A participant may contribute up to 10 percent of his or her cashearnings through payroll deductions and the accumulated payroll deductions willbe applied to the purchase of shares on the participant’s behalf on eachsemi-annual purchase date (the last business day in May and November).  The purchase price per share will be 85percent of the lower of the fair market value of the Company’s common stock on theparticipant’s entry date into the offering period or the fair market value onthe semi-annual purchase date.

 

The Company’s board of directors may at any time amendor modify the plan.  The plan willterminate no later than the last business day in April 2010.

 

On November 28, 2003, employees participating in theCompany’s employee stock purchase plan acquired approximately 341,000 shares ofthe Company’s common stock at an average purchase price of $1.09 per share.

 

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**(8)   SIGNIFICANT CUSTOMERS**

 

During the three months ended January 31, 2004, TechData Corporation accounted for approximately 10 percent of total revenue.  During the three months ended January 31,2003, the Company did not have any customers that accounted for more than 10percent of total revenue.

 

**(9)   SEGMENT INFORMATION**

 

The Company’s resources are allocated and operatingresults managed to the operating income (loss) level for each of the Company’stwo geographic units for its UNIX division and the Company’s SCOsource licensingdivision.  The geographic units for theUNIX division consist of the Americas division and the Internationaldivision.  The revenue, cost of revenueand direct sales and marketing expenses are tracked for each division.  The costs of corporate sales and marketing,research and development and general and administration are allocated to eachdivision based on that divisions’ percentage of total revenue.  The corporate revenue and expenses includeamounts not directly attributable to a specific division.

 

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

 

|                       |   | **Three  Months Ended January 31, 2004** |   |
|----------------------------|--------|------------------------------------------|--------|
|                       |   | **Americas**                             |   | **International** |   | **SCOsource** |   | **Corporate** |   | **Total** |   |
|                       |   |                                     |   |   |   |   |   |   |   |   |   |
| Revenue                    |   | $                                        | 6,763  |   | $ | 4,673 |   | $ | 20 |   | $ | (64 | ) | $ | 11,392 |   |
| Cost of revenue            |   | 1,370                                    |   | 818 |   | 3,440 |   | 22 |   | 5,650 |   |
| Gross margin               |   | 5,393                                    |   | 3,855 |   | (3,420 | ) | (86 | ) | 5,742 |   |
| Sales and marketing        |   | 2,543                                    |   | 2,468 |   | 10 |   | — |   | 5,021 |   |
| Research and development   |   | 1,597                                    |   | 1,083 |   | 27 |   | — |   | 2,707 |   |
| General and administrative |   | 1,294                                    |   | 878 |   | 22 |   | — |   | 2,194 |   |
| Other                      |   | —                                   |   | — |   | — |   | 989 |   | 989 |   |
| Total operating expenses   |   | 5,434                                    |   | 4,429 |   | 59 |   | 989 |   | 10,911 |   |
| Loss from operations       |   | $                                        | (41    | ) | $ | (574 | ) | $ | (3,479 | ) | $ | (1,075 | ) | $ | (5,169 | ) |

 

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

 

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

 

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

 

**(10) SUBSEQUENT EVENTS**

 

**End User Lawsuits**

 

On or around March 2, 2004, the Company brought suit against AutoZone,Inc. (“AutoZone”) for its alleged violations of the Company’s UNIX copyrightsthrough its use of Linux.  Specifically,the lawsuit alleges that AutoZone violated the Company’s UNIX copyrights byrunning versions of the Linux operating system that contain code, structure,sequence and/or organization from the Company’s proprietary UNIX System V codein violation of its copyrights.  Thelawsuit filed in U.S. District Court in Nevada requests injunctive reliefagainst AutoZone’s further use or copying of any part of the Company’scopyrighted materials and also requests damages as a result of AutoZone’sinfringement in an amount to be proven at trial.

 

On or around March 3, 2004, the Company brought suitagainst DaimlerChrysler Corporation (“DaimlerChrysler”) for its allegedviolations of its UNIX software agreement with the Company.  Specifically, the lawsuit alleges thatDaimlerChrysler breached its UNIX software agreement with the Company byfailing to certify by January 31, 2004 its compliance with the UNIX softwareagreement as required by the Company. The lawsuit, filed in Oakland County Circuit Court in the State ofMichigan, requests the court to issue orders declaring that DaimlerChrysler hasviolated the certification requirements of its UNIX software agreement,permanently enjoin DaimlerChrysler from further violations of the UNIX softwareagreement, issue a mandatory injunction requiring DaimlerChrysler to remedy theeffects of its past violations of the UNIX software agreement and award theCompany damages in amount to be determined at trial together with costs,attorneys’ fees and any such other or different relief that the Court may deemto be equitable and just.

 

**ExchangeAgreement with Series A Investors**

 

On February 5, 2004, the Company completed anexchange transaction in which each outstanding share of redeemableSeries A Convertible Preferred Stock was exchanged for one share of theCompany’s new redeemable Series A-1 Convertible Preferred Stock.  The exchange transaction eliminated thederivative related to the redeemable Series A Convertible Preferred Stockthat has been recorded as a current liability on the Company’s balance sheetand, after February 5, 2004, eliminates the charge in the Company’s quarterlystatements of operations for the change in the fair value of the derivativerelated to the redeemable Series A Convertible Preferred Stock.  The derivative was eliminated due to certainrights and privileges included in the new redeemable Series A-1 ConvertiblePreferred Stock such as voting rights and rights to board representation, amongothers, that were not included in the redeemable Series A Convertible PreferredStock.

 

The Companyanticipates recording other income in the second quarter of fiscal year 2004related to the change in the fair value of the Series A derivative betweenJanuary 31, 2004 and February 5, 2004, the date on which the exchange agreementwas executed.  The Company alsoanticipates recording a dividend 

 

17

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 in the second quarter of fiscal year 2004,related to the difference between the fair value of the new redeemableSeries A-1  Convertible PreferredStock and the carrying value of the previously issued redeemable Series AConvertible Preferred Stock and related derivative.  This dividend will reduce earnings available to commonstockholders.

 

**StockRepurchase Program**

 

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

 

The repurchaseprogram will allow the Company to repurchase its shares from time to time inaccordance with the requirements of the Securities and Exchange Commission onthe open market, in block trades and in privately negotiated transactions,depending on market conditions and other factors.

 

18

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

 

*This Management’s Discussion andAnalysis of Financial Condition and Results of Operations and other parts ofthis quarterly report on Form 10-Q contain forward-looking statements thatinvolve risks and uncertainties. Forward-looking statements can also be identified by words such as“intends,” “anticipates,” “expects,” “believes,” “plans,” “predicts,” andsimilar terms.  Forward-lookingstatements are not guarantees of future performance and our actual results maydiffer significantly from the results discussed in the forward-lookingstatements.  Factors that might causesuch differences include, but are not limited to, those set forth below under“Forward-Looking Statements” and “Risk Factors” and elsewhere in this Form10-Q. The following discussion should be read in conjunction with ourconsolidated financial statements and notes thereto included in this Form 10-Qand our annual report on Form 10-K for the year ended October 31, 2003 filedwith the Securities and Exchange Commission, including the audited financialstatements and management’s discussion and analysis contained therein.  All information presented herein is based onour quarter ended January 31, 2004.  Weassume no obligation to revise or update any forward-looking statements for anyreason, except as required by law.*

 

**Overview**

 

*HistoricalBackground. *We originally incorporated as CalderaSystems, Inc., a Utah corporation (“Caldera Systems”), on August 21, 1998, 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 holding company in Delawareunder the name of Caldera International, Inc. to acquire substantially all ofthe assets and operations of the server and professional services groups of TheSanta Cruz Operation (now known as Tarantella, Inc.).  In connection with this acquisition, Caldera Systems became awholly-owned subsidiary of Caldera International, Inc.  Former holders of shares and options to purchaseshares of Caldera Systems received an equal number of shares and options topurchase shares in CalderaInternational, Inc.  OnMay 16, 2003, our stockholders approved our corporate name change to The SCOGroup, Inc.

 

*Recent Developments.*On October 16, 2003,we completed a $50,000,000 private placement of 50,000 shares of our redeemableSeries A Convertible Preferred Stock and received net proceeds ofapproximately $47,740,000.  On February5, 2004, we completed an exchange transaction in which each outstanding shareof redeemable Series A Convertible Preferred Stock was exchanged for one shareof our new redeemable Series A-1 Convertible Preferred Stock.  The exchange transaction eliminated thederivative related to the redeemable Series A Convertible Preferred Stockthat was recorded as a current liability on our balance sheet and, afterFebruary 5, 2004, eliminates the charge in our quarterly statements ofoperations for the change in the fair value of the derivative related to theredeemable Series A Convertible Preferred Stock.  The derivative was eliminated due to certain rights and privilegesincluded in the new redeemable Series A-1 Convertible Preferred Stock such asvoting rights and rights to board representation, among others,  that were not included in the redeemableSeries A Convertible Preferred Stock.

 

We anticipate recording other income in the second quarter of fiscal year2004 related to the change in the fair value of the derivative between January31, 2004 and February 5, 2004, the effective date of our exchangetransaction.  We also anticipaterecording a dividend in the second quarter of fiscal year 2004, related to thedifference between the fair value of the new redeemable Series A-1 ConvertiblePreferred Stock and the carrying value of the previously issued redeemableSeries A Convertible Preferred Stock and related derivative.  This dividend will reduce earnings to commonstockholders.

 

19

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On or about January 20, 2004, we brought suit againstNovell, Inc. for slander of title seeking relief for Novell’s alleged badfaith efforts to interfere with our copyrights related to its UNIX source codeand derivative works and our UnixWare product. In the lawsuit, we request preliminary and permanent injunctive reliefas well as damages. The injunction would require Novell to assign to us allcopyrights that we believe Novell has wrongfully registered, prevent Novellfrom representing any ownership interest in those copyrights and require Novellto retract or withdraw all representations it has made regarding its purportedownership of those copyrights.  The caseis currently pending in the Third Judicial District Court in Salt Lake County,Utah.  Novell has not yet answered ourcomplaint but has filed with the United States District Court for the Districtof Utah a notice removing the case to such federal court and a motion with theThird Judicial District Court in Salt Lake County, Utah to transfer the venueof the case from such court to the Fourth Judicial District Court in UtahCounty, Utah. Neither court has ruled on these actions. Novell also filed amotion to dismiss our complaint claiming it never transferred the copyrights toThe Santa Cruz Operation.  We have fileda response to Novell’s motion to dismiss and have also filed a motion to remandthe case back to the state court.  Thecourt has not ruled on these motions. We plan to vigorously pursue our claims against Novell.

 

On or about March 2, 2004, we brought suit against AutoZone, Inc. forits alleged violations of our UNIX copyrights through its use of Linux.  Specifically, the lawsuit alleges thatAutoZone violated our UNIX copyrights by running versions of the Linuxoperating system that contain code, structure, sequence and/or organizationfrom our proprietary UNIX System V code in violation of our copyrights.  The lawsuit filed in U.S. District Court inNevada requests injunctive relief against AutoZone’s further use or copying ofany part of our copyrighted materials and also requests damages as a result ofAutoZone’s infringement in an amount to be proven at trial.

 

On or about March 3, 2004, we brought suit againstDaimlerChrysler Corporation for its alleged violations of its UNIX softwareagreement with us.  Specifically, thelawsuit alleges that DaimlerChrysler breached its UNIX software agreement withus by failing to voluntarily certify by January 31, 2004 its compliance withthe UNIX software agreement as required by us. The lawsuit, filed in Oakland County Circuit Court in the State ofMichigan, requests the court to issue orders declaring that DaimlerChrysler hasviolated the certification requirements of its UNIX software agreement,permanently enjoin DaimlerChrysler from further violations of the UNIX softwareagreement, issue a mandatory injunction requiring DaimlerChrysler to remedy theeffects of its past violations of the UNIX software agreement and award usdamages in amount to be determined at trial together with costs, attorneys’fees and any such other or different relief that the Court may deem to beequitable and just.

 

On March 10, 2004, our board of directors authorizedmanagement, in its discretion, to purchase up to 1,500,000 shares of our commonstock over a 24-month period.  Sharesmay be purchased in open market transactions, block purchases or privatelynegotiated transactions.  Anyrepurchased shares will be held as treasury stock and will be available forgeneral corporate purposes.

 

**Business Focus**

 

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

 

*UNIXBusiness. *Our UNIX business serves the needs of small-to-medium sizedbusinesses, including replicated site franchisees of Fortune 1000 companies, byproviding reliable, cost effective UNIX operating systems and software productsto power computers running on Intel architecture.  Our largest source of UNIX business revenue is derived from ourworldwide, indirect, leveraged channel of partners, which includes distributorsand independent solution providers.  Wehave local offices in a number of countries that provide support and servicesto

 

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customers and resellers in that geographicarea.  The other principal channel forselling and marketing our UNIX products is through major corporations that havea large number of replicated sites or franchisees.  We access these corporations through their information technologyor purchasing departments with our Area Sales Managers in the United States andthrough our reseller channel in countries outside the United States.  In addition, we also sell our operatingsystem products to OEMs.  Until fiscalyear 2003, the majority of our revenue and our operating expenses were derivedfrom our UNIX business.

 

Therevenue derived from our UNIX business was $11,372,000 and $13,540,000 for thethree months ended January 31, 2004 and 2003, respectively.  The revenue from this business has beendeclining in each of the last four years primarily as a result of increasedcompetition from alternative operating systems, particularly Linux, lowerinformation technology spending and the general economic slowdown.  If we are unable to generate positive cash flow andprofitable operations, our UNIX operations may be adversely impacted.

 

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

 

Inan effort to offset this decrease in UNIX revenue, we have decreased ouroperating costs and increased our gross margin percentage over the last threefiscal years.  Operating costs decreasedfrom $11,400,000 for the three months ended January 31, 2003 to $10,911,000 forthe three months ended January 31, 2004. We have reduced the number of employees from 339 as of January 31, 2003to 303 as of January 31, 2004, eliminated redundant facilities and reducedother discretionary spending while still preserving our worldwideinfrastructure.  Our gross marginpercentage from our UNIX business increased from 79 percent for the threemonths ended January 31, 2003, to 81 percent for the three months ended January31, 2004.  We have accomplished this byreducing excess manufacturing and overhead costs, reducing our third-partyroyalty and technology costs and decreasing the number of employees in ourservices organization.

 

Animportant initiative for our UNIX business for our 2004 fiscal year will becontinuing to maintain the level of investment in and commitment to our UNIXoperating systems.  As part of thisinitiative, we intend to continue to invest in research and development effortsfor our UNIX division for fiscal year 2004 to provide our OpenServer andUnixWare products with increased system reliability, maintain backwardcompatibility with existing applications and software, provide increasedapplication support, provide additional hardware support, integrate widely usedinternet applications and increase system performance.  These enhancements will not have a directimpact on our short-term UNIX revenue because of the long adoption cycle fornew operating system purchases and our long operating system product salescycle.

 

*SCOsourceBusiness. *During the 2003 fiscal year, we became aware that our UNIX codeand derivative 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, 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.

 

21

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Tooffset the decline in our UNIX business and review the status of our UNIXlicensing and sublicensing agreements, we initiated our SCOsource licensing initiatives inJanuary 2003.  These initiatives nowinclude, among others, seeking to enter into license agreements with UNIXvendors and implementing a worldwide program offering SCOsource intellectualproperty (“IP”) licenses to Linux end users allowing them to continue to useour UNIX source code and derivative works found in Linux.  Our SCOsource efforts resulted in theexecution of two significant vendor license agreements during fiscal year2003.  In fiscal year 2004, we plan toincrease our SCOsource sales team as we continue to implement our SCOsourcelicensing strategies.

 

Ourfuture success with our SCOsource initiatives and future revenue from SCOsourcelicenses will depend on our ability to protect our UNIX intellectualproperty.  We will continue to devoteresources to our SCOsource initiatives, and we generally expect quarterly legalfees and other SCOsource related costs for the remaining quarters of fiscalyear 2004 will be consistent with the level of costs incurred in the firstquarter of fiscal year 2004,.  However, legal expenses couldincrease over time depending on developments in the litigation involving us,and certain events may take place that could require us to pay a 20 percentcontingency fee to our law firms.  Theseevents may include settlements, judgments, licensing fees, subject to certainexceptions, and a sale of our company during the pendancy of litigation orthrough settlement, subject to agreed upon credits for amounts received asdiscounted hourly fees and unused retainer fees.  Additionally, our agreement with our law firms may also beconstrued to include contingency fee payments in connection with any issuanceof our equity securities.

 

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

 

**Critical Accounting Policies**

 

Our critical accounting policies and estimatesinclude the following:

 

•                                          Revenue recognition;

 

•                                          Deferred income taxes and related valuation allowances;

 

•                                          Fair value of derivative financial instrument;

 

•                                          Impairment of long-lived assets; and

 

•                                          Allowances for doubtful accounts.

 

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

 

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recognize product revenuefrom royalty payments upon receipt of quarterly royalty reports from OEMsrelated to their product sales.

 

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

 

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

 

*Deferred Income Taxes and RelatedValuation Allowance*.  The amount, and ultimate realization, of ourdeferred income tax assets depends, in part, upon the tax laws in effect, ourfuture earnings and other future events, the effects of which cannot bedetermined.  We have provided avaluation allowance of $52,908,000 against our entire net deferred tax asset asof October 31, 2003.  The valuationallowance was recorded because of our history of net operating losses and theuncertainties regarding our future operating profitability and taxable income.

 

*Fair Value of Derivative FinancialInstrument*.  On October 16, 2003, we issued 50,000 sharesof our redeemable Series A Convertible Preferred Stock for $1,000 pershare.  The net proceeds from the saleof the preferred stock were $47,740,000. The terms of the preferred stock include conversion and a number ofredemption provisions that represent a derivative financial instrument underSFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,”as amended.  We determined that theconversion feature allowing the holders of the preferred stock to acquirecommon shares is an embedded derivative financial instrument that does notqualify as a scope exemption under the provisions of Emerging Issues Task Force(“EITF”) 00-19, “Accounting for Derivative Financial Instruments Indexed to,and Potentially Settled in a Company’s Own Stock.”

 

As of October 16, 2003, through the assistance of anindependent valuation firm, we determined the initial fair value of the derivativewas $18,069,000 and the value of the preferred stock was $29,671,000.  We were required to account for theconversion feature as an embedded derivative since the preferred stockinstrument did not entitle the holders to equity features such as voting rightsand board representation.  As of October31, 2003, the fair value of the derivative was $15,224,000 and the decrease infair value of $2,845,000 was recorded as other income in the statement ofoperations for fiscal year 2003.  As ofJanuary 31, 2004, the fair value of the derivative was $11,600,000 and thedecrease in fair value of $3,624,000 was recorded as other income in ourcondensed consolidated statement of operations for the three months endedJanuary 31, 2004.  Significant estimatesused by management in the valuation of the derivative as of January 31, 2004included an expected term of three years, a yield rate for the security of 15percent and the value of our common stock of $14.37.

 

On February 5, 2004, we completed an exchangetransaction in which each outstanding share of redeemable Series A ConvertiblePreferred Stock was exchanged for one share of our new redeemable Series A-1Convertible Preferred Stock. The exchange transaction eliminated the

 

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derivative related to theredeemable Series A Convertible Preferred Stock that was initially recorded asa current liability on our balance sheet and eliminates the charge in ourquarterly statements of operations for the change in the fair value of thederivative related to the redeemable Series A Convertible Preferred Stock.  The derivative was eliminated due to certainrights and privileges  included in thenew redeemable Series A-1 Convertible Preferred Stock such as voting rights andrights to board representation, among others, that were not included in theredeemable Series A Convertible Preferred Stock.

 

We anticipate recording other income in the secondquarter of fiscal year 2004, related to the change in the fair value of thederivative between January 31, 2004 and February 5, 2004, the time at which theexchange agreement was executed.  Wealso anticipate recording a dividend in the second quarter of fiscal year 2004,related to the difference between the fair value of the new redeemable SeriesA-1 Convertible Preferred Stock and the carrying value of the previously issuedredeemable Series A Convertible Preferred Stock and related derivative.  This dividend will reduce earnings to commonstockholders.

 

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

 

We performed an impairment analysis as of January 31,2004 in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,”and determined that the goodwill reported in the consolidated balance sheets isnot impaired.  Write-downs of intangibleassets may be necessary if the future fair value of these assets is less thancarrying value.  If the operating trendsfor our UNIX business continue to decline or the value of our common stock wereto significantly decrease, we may be required to record an impairment charge ina future period related to the carrying value of our intangible assets withfinite lives.  If we are not able togenerate revenue in future quarters from our web services technology acquiredfrom Vultus, Inc. in fiscal year 2003, we may be required to record animpairment charge in a future period related to the carrying value of ourgoodwill and intangible assets with finite lives.

 

*Allowance for Doubtful Accounts*.  We offer credit terms on the sale of ourproducts to a majority of our customers and require no collateral from thesecustomers.  We perform ongoing creditevaluations of our customers’ financial condition and maintain an allowance fordoubtful accounts based upon our historical collection experience and expectedcollectibility of all accounts receivable and have applied these policiesconsistently throughout the three months ended January 31, 2004.  Our allowance for doubtful accounts based onour historical experience and specific review as of January 31, 2004, wasapproximately $231,000.  Our pastexperience has resulted in minimal differences from the actual amounts providedfor bad debts and our recorded estimates. However, our actual bad debts in future periods may differ from ourcurrent estimates and the differences may be material, which may have an adverse impact on ourfuture accounts receivable and cash position.

 

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**Results of Operations**

 

The following table presents our results of operationsfor the three months ended January 31, 2004 and 2003:

 

|                                                         |   | **Three Months Ended January 31,** |   |
|--------------------------------------------------------------|--------|------------------------------------|--------|
|                                                         |   | **2004**                           |   | **2003** |   |
| **Statement of Operations Data:**                            |   |                               |   |   |   |
|                                                         |   |                               |   |   |   |
| Revenue:                                                     |   |                               |   |   |   |
| Products                                                     |   | $                                  | 9,712  |   | $ | 11,090 |   |
| SCOsource licensing                                          |   | 20                                 |   | — |   |
| Services                                                     |   | 1,660                              |   | 2,450 |   |
| Total revenue                                                |   | 11,392                             |   | 13,540 |   |
| Cost of revenue:                                             |   |                               |   |   |   |
| Products                                                     |   | 888                                |   | 1,186 |   |
| SCOsource licensing                                          |   | 3,440                              |   | — |   |
| Services                                                     |   | 1,322                              |   | 1,692 |   |
| Total cost of revenue                                        |   | 5,650                              |   | 2,878 |   |
| Gross margin                                                 |   | 5,742                              |   | 10,662 |   |
| Operating expenses:                                          |   |                               |   |   |   |
| Sales and marketing                                          |   | 5,021                              |   | 6,440 |   |
| Research and development                                     |   | 2,707                              |   | 2,650 |   |
| General and administrative                                   |   | 2,194                              |   | 1,650 |   |
| Restructuring charges (reversals)                            |   | —                             |   | (252 | ) |
| Amortization of intangibles                                  |   | 787                                |   | 700 |   |
| Stock-based compensation                                     |   | 202                                |   | 212 |   |
| Total operating expenses                                     |   | 10,911                             |   | 11,400 |   |
| Loss from operations                                         |   | (5,169                             | )      | (738 | ) |
| Equity in income (losses) of affiliates                      |   | 37                                 |   | (25 | ) |
| Other income, net                                            |   | 3,763                              |   | 44 |   |
| Provision for income taxes                                   |   | (128                               | )      | (5 | ) |
| Net loss                                                     |   | (1,497                             | )      | (724 | ) |
| Dividends on Series A Redeemable Convertible Preferred Stock |   | (756                               | )      | — |   |
| Net loss applicable to common stockholders                   |   | $                                  | (2,253 | ) | $ | (724 | ) |

 

**THREE MONTHS ENDED JANUARY31, 2004 AND 2003**

 

### ***Revenue***

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

 

Revenuefor the first quarter of fiscal year 2004 decreased by $2,148,000, or 16percent, from the first quarter of fiscal year 2003, and this decrease wasprimarily attributable to decreased UNIX products and services revenue.

 

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

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

 

The decreasein revenue from our International division for the first quarter of fiscal year2004 compared to the first quarter of fiscal year 2003 was primarily related tothe negative impact of the slowing European economy as well as from increasedcompetition from other operating system products, particularly Linux, in Europeand Asia.  We anticipate for theremainder of the 2004 fiscal year that UNIX revenue generated in the Americasand the International divisions will be consistent with or slightly lower thanrevenue generated in the first quarter of fiscal year 2004 and that thepercentage split between these two UNIX divisions will be generally consistentwith that in the first quarter of fiscal year 2004.  Our UNIX product and services revenue may be lower than currentlyanticipated if we lose the support of any of our existing hardware and softwarevendors or our key industry partners withdraw their marketing and certificationsupport or direct their support to our competitors.  This may occur as a result of our SCOsource initiatives and inparticular as a result of any lawsuits we have brought and may bring againstend users violating our intellectual property and contractual rights.

 

*Products Revenue*

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

 

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

 

Thedecrease in products revenue in the first quarter of fiscal year 2004 ascompared with the first quarter of fiscal year 2003 was primarily attributableto decreased sales of UnixWare and other products primarily resulting fromincreased competition in the operating system market, particularly Linux, andfrom a decrease in information technology spending and the worldwide economicslowdown.  This impact was felt in allof our distribution channels, and we believe that this competition from Linuxwill continue in future periods.

 

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

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

 

*SCOsource LicensingRevenue*

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

 

SCOsourcelicensing revenue was $20,000 for first quarter of fiscal year 2004 as comparedto no revenue from this source for the first quarter of fiscal year 2003.  This revenue is the result of our SCOsourceinitiatives launched beginning in January 2003, including our recentlyannounced worldwide SCOsource IP licensing program.  We initiated our SCOsource initiatives to protect ourintellectual property rights in our UNIX source code.  We anticipate increased revenue during future quarters of fiscalyear 2004 from our SCOsource activities in the form of vendor licenses and IPlicenses.  However, we are unable topredict the amount and timing of revenue from our SCOsource initiatives forfuture periods because of the uncertainties related to SCOsource licensingrevenue.

 

*Services Revenue*

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

 

Servicesrevenue consists primarily of annual and incident support fees, engineeringservices fees, professional services and education fees.  These fees are typically charged andinvoiced separately from UNIX products sales. The $790,000 decrease in services revenue in the first quarter of fiscalyear 2004 as compared to the first quarter of fiscal year 2003 was in part dueto a decrease in professional services resulting from a decrease in the demandfor our custom enterprise-level projects as well as from a decrease in oursupport services, engineering services and team services agreements.

 

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

 

27

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*Cost of Products Revenue*

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

 

Costof products revenue includes primarily overhead costs, manufacturing costs,royalties to third-party vendors and technology costs.  Cost of products revenue decreased by$298,000 in the first quarter of fiscal year 2004 compared to the first quarterof fiscal year 2003.  This decrease wasprimarily attributable to reduced overhead and manufacturing costs resultingfrom our cost reduction efforts, decreased royalties to third party vendors andlower amortized technology costs.

 

Forthe remaining quarters of fiscal year 2004, we expect the dollar amount of ourcost of products revenue to be consistent to our cost of products revenueincurred in the first quarter of fiscal year 2004.

 

*Cost of SCOsource LicensingRevenue*  

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

 

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

 

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

 

*Cost of Services Revenue*

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

 

Costof services revenue includes the salaries and related personnel costs ofemployees delivering services revenue as well as third-party serviceagreements.  Cost of services revenue decreasedby $370,000 for the first quarter of fiscal year 2004 compared to the firstquarter of fiscal year 2003.  Thisdecrease was attributable to reduced employee and related costs in our

 

28

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

 

Forthe remaining quarters of fiscal year 2004, we expect the dollar amount of ourcost of services revenue to be slightly lower than our cost of services revenueincurred in the first quarter of fiscal year 2004.

 

*Sales and Marketing*

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

 

Salesand marketing expenses consist of the salaries, commissions and other personnelcosts of employees involved in the revenue generation process, as well asadvertising and corporate allocations. The decrease in sales and marketing expenses from the first quarter offiscal year 2003 to the first quarter of fiscal year 2004 of $1,419,000 wasprimarily attributable to reductions in sales and marketing employees,reduced travel expenses, and lower commissions and lower co-operativeadvertising costs as a result of lower revenue.  Our sales and marketing personnel decreased from 142 as ofJanuary 31, 2003, to 100 as of January 31, 2004.

 

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

 

*Research and Development*

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

 

Researchand development expenses consist of the salaries and benefits of softwareengineers, consulting expenses as well as corporate allocations.  The increase in research and developmentexpense in the first quarter of fiscal year 2004 of $57,000 compared to thefirst quarter of fiscal year 2003 was primarily attributable to increaseddevelopment work and enhancements of our two UNIX operating system products,OpenServer and UnixWare.  Our researchand development personnel increased from 79 as of January 31, 2003, to 86 as ofJanuary 31, 2004.

 

Forthe remaining quarters of fiscal year 2004, we anticipate the dollar amount ofresearch and development expenses will remain consistent with, or increaseslightly compared to, the first quarter of fiscal year 2004.

 

*General and Administrative*

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

 

Generaland administrative expenses consist of the salaries and benefits of finance,human resources and executive management and expenses for professional servicesas well as

 

29

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corporate allocations.  The increase in general and administrativeexpense from the first quarter of fiscal year 2003 compared to the firstquarter of fiscal year 2004 of $544,000 was primarily attributable to new complianceand reporting regulations under the Sarbanes-Oxley Act of 2002 and other newregulatory requirements, increased legal costs as a result of corporate legalmatters and other legal and professional costs not categorized as SCOsourcecost of revenue as well as from increased personnel and related costs.  Our general and administrative personnelincreased from 52 as of January 31, 2003 to 60 as of January 31, 2004.

 

Forthe remaining quarters of fiscal year 2004, we anticipate the dollar amount ofgeneral and administrative expenses will be lower than those costs incurred inthe first quarter of fiscal year 2004.

 

*Restructuring Charges (Reversals)*

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

 

During the first quarter of fiscal year 2003, we recorded a reversal ofa previously recorded restructuring charge of $252,000.  The net restructuring charge for the firstquarter of fiscal year 2003 was comprised of adjustments to previously recordedrestructuring charges for actual payments made.

 

*Amortizationof Intangibles*

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

 

The increase in amortization of intangiblesof $87,000 for the first quarter of fiscal year 2004 compared to the firstquarter of fiscal year 2003 was primarily attributable to amortization expenserecorded on certain assets and technology acquired from Vultus, Inc.

 

*Stock-based Compensation*

 
|                        |   | **Three Months Ended January 31,** |    |
|-----------------------------|--------|------------------------------------|---------|
|                        |   | **2004**                           |    | **Change** |   | **2003** |   |
|                        |   |                               |    |   |   |   |   |
| Stock-based compensation    |   | $                                  | 202,000 |   | (5 | )% | $ | 212,000 |   |
| Percentage of total revenue |   | 2                                  | %       |   |   | 2 | % |
|                             |        |                                    |         |  |  |  |  |  |  |

 

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

 
|                                     |   | **Three Months Ended January 31,** |   |
|------------------------------------------|--------|------------------------------------|--------|
|                                     |   | **2004**                           |   | **2003** |   |
|                                     |   |                               |   |   |   |
| Amortization of stock-based compensation |   | $                                  | 110    |   | $ | 156 |   |
| Options and shares for services          |   | —                             |   | 56 |   |
| Modifications to options                 |   | 92                                 |   | — |   |
| Total                                    |   | $                                  | 202    |   | $ | 212 |   |

 

30

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*Equity in Income(Losses) of Affiliates*

 

We account for our ownership interests in companies that we own atleast 20 percent and less than 50 percent using the equity method ofaccounting.  Under the equity method, werecord our portion of the entities’ net income or net loss in our condensedconsolidated statements of operations. During the first quarter of fiscal year 2004 we recorded income of$37,000 primarily related to income from our joint venture in China compared toa loss of $25,000 in the first quarter of fiscal year 2003 primarily related toour investment in Vista, Inc.

 

*Other Income(Expense), net*

 

Other income (expense) consisted of the following components for thethree months ended January 31, 2004 and 2003 (in thousands): 

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

 

Interest income increased by $231,000 for the first quarter of fiscalyear 2004 compared to the first quarter of fiscal year 2003 as a result ofinterest earned on higher cash balances. The income recorded on the change in fair value of the derivative was aresult of the difference in the fair value between January 31, 2004 andOctober 31, 2003.  We anticipaterecording other income in the second quarter of fiscal year 2004 related to thechange in the fair value of the derivative between January 31, 2004 andFebruary 5, 2004, the time at which the exchange agreement was executed.

 

*Provision for IncomeTaxes*

 

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

 

*Dividends Related toConvertible Preferred Stock*

 

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

 

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**Liquidity and CapitalResources**

 

Our cash and equivalents balance decreased from $64,428,000 as ofOctober 31, 2003 to $57,945,000 as of January 31, 2004, however, ourworking capital increased from $37,168,000 as of October 31, 2003 to$37,330,000 as of January 31, 2004. During fiscal year 2003, we generated positive cash flow from operationsfor the first time in our operating history. This was achieved through reductions in costs and increased gross margingenerated from our UNIX business and significant license revenue generated fromour SCOsource business.  We alsocompleted the placement of 50,000 shares of our redeemable Series A ConvertiblePreferred Stock for net proceeds of $47,740,000 in October 2003, whichshares were exchanged for shares of redeemable Series A-1 Convertible PreferredStock in February 2004.  We intendto use the proceeds from our preferred stock financing as well as our othercash resources to maintain and enhance our UNIX business and pursue ourSCOsource initiatives.  We believe thatwe will have sufficient cash resources to fund our current operations for atleast the next 12 months.

 

Our net cash used in operations during the first quarter of fiscal year2004 was $4,319,000.  Cash used inoperations was attributable to a net loss of $1,497,000, non-cash expenses of$2,336,000 and from changes in operating assets and liabilities of$486,000.  Our current liabilitiesdecreased from $45,112,000 to $38,942,000 during the first quarter of fiscalyear 2004 primarily related to the decrease in the fair-value of the derivativerelated to the redeemable Series A Convertible Preferred Stock and the decreasein accrued compensation to law firms.

 

Ourinvesting activities have historically consisted of equipment purchases,investing in strategic partners and the purchase and sale of available-for-salesecurities.  During the first quarter offiscal year 2004, cash used in investing activities was $2,798,000, which wasprimarily a result of our purchase of available-for-sale securities of$4,035,000 and equipment purchases of $131,000, offset by proceeds receivedfrom the sale of available-for-sale securities of $1,368,000.

 

Our financing activitiesprovided $667,000 during the first quarter of fiscal year 2004 and consistedprimarily of proceeds received from the exercise of stock options of $297,000and proceeds from the purchase of shares of common stock by our employees throughour employee stock purchase program of $370,000.

 

The certificate ofdesignation creating our redeemable Series A-1 Convertible Preferred Stockincludes redemption provisions that if triggered would require us to repurchasefor cash the outstanding shares of our redeemable Series A-1 ConvertiblePreferred Stock.  Our redemptionobligation  may be triggered by certainevents including, among others, our company or any of its subsidiaries makingan assignment for the benefit of creditors or consenting to the appointment ofa trustee or receiver for it or a substantial part of its business, thebankruptcy, reorganization, liquidation or similar proceedings instituted by oragainst our company or any of its subsidiaries, a change in control eventoccurring with respect to our company or our failure to pay when due anyindebtedness in excess of $1,000,000 or otherwise our default under anyagreement binding our company that would likely result in a material adverseeffect on our business.  If we wererequired to pay cash to the holders of our redeemable Series A-1 ConvertiblePreferred Stock, it would have a material impact on our liquidity, which mayrequire us to obtain additional sources of cash to sustain operations.

 

Dividendson our redeemable Series A-1 Convertible Preferred Stock will be paid fromOctober 16, 2004, the first anniversary of the October 16, 2003closing of our redeemable Series A Convertible Preferred Stock privateplacement, and will be paid quarterly beginning in the 30-day period followingJanuary 31, 2005 at a rate of 8 percent perannum, subject to annual increases of 2 percent per annum, not to exceed 12percent per annum.  Becausedividends are not payable during the first year the preferred stock isoutstanding, we have accrued dividends of $756,000 for the first quarter offiscal year 2004.  Dividends may be paidin cash or additional

 

32

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shares of our redeemable Series A-1 Convertible Preferred Stock at ourelection, subject to certain limitations.

 

Our net accountsreceivable balance decreased from $9,282,000 as of October 31, 2003 to$9,151,000 as of January 31, 2004. The majority of our accounts receivable are current and our allowancefor doubtful accounts was approximately $231,000 as of January 31, 2004,which represented approximately 2 percent of our gross accounts receivablebalance.  This allowance as a percentageof gross accounts receivable is consistent with our experience in priorperiods, and we expect this trend to continue. Our write-offs of uncollectible accounts during the first quarter offiscal year 2004 were not significant.

 

During fiscal year 2003,we expanded our efforts with the law firms assisting us with our pursuit of ourintellectual property claims and currently expect to devote substantially morefinancial resources to this effort.  Inaddition to paying fees at reduced hourly rates to these firms, our agreementwith the law firms provides that we will pay the law firms a contingency fee of20 percent of the proceeds from specified events related to the protection ofour intellectual property rights.  Theseevents may include settlements, judgments, certain licensing fees, subject tocertain exceptions, and a sale of our company during the pendancy of litigationor through settlement, subject to agreed upon credits for amounts received asdiscounted hourly fees and unused retainer fees.  Additionally, our agreement with the law firms may also beconstrued to include contingency fee payments in connection with our issuanceof equity securities, which may harm our results of operations as we anticipatethat these costs to the law firms will be expensed as incurred.

 

We expect that legal feesfor the remaining quarters of fiscal year 2004 paid to the law firms we haveengaged to pursue our intellectual property claims will be consistent to thelevel of fees incurred during the first quarter of fiscal year 2004.  However, legal expenses could increase overtime depending on developments in litigation involving us, and certain eventsoutside of our control could occur or certain contingent events could takeplace that would require us to pay additional fees to the law firms.  To the extent that our SCOsource relatedcosts and legal fees exceed our budgeted amounts in future quarters of fiscalyear 2004 or SCOsource revenue is below our expectations, our liquidity will beadversely impacted and fewer financial resources will be available for otherinitiatives such as maintaining and enhancing our UNIX business.  Additionally, future contingency feespayable to the law firms may be significant in future periods, which may havean adverse impact on our liquidity.  Ourcompensation arrangement with our law firms could also impair our ability toraise equity capital in future periods.

 

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

 

The following tablesummarizes our contractual lease obligations as of January 31, 2004:

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

 

33

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As of January 31,2004, we did not have any long-term debt obligations, purchase obligations ormaterial capital lease obligations.

 

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

 

In the event that cash required to fund operations and strategic initiativesexceeds our current cash resources and cash generated from operations, we willbe required to reduce costs and perhaps raise additional capital.  We may not be able to reduce costs in amanner that does not impair our ability to maintain our UNIX business andpursue our SCOsource initiatives.  Wemay also not be able to raise capital for any number of reasons including thoselisted under the section “Risk Factors” below.  Our ability to raise additional equity capital is restrictedunder the terms of our Series A-1 Convertible Preferred Stock.  If additional equity financing is available,it may not be available to us on attractive terms and may be dilutive to ourexisting stockholders.  Our ability toraise debt financing is restricted under the terms of our Series A-1Convertible Preferred Stock.  Inaddition, if our stock price declines, we may not be able to access the publicequity markets on acceptable terms, if at all. Our ability to effect acquisitions for stock would also be impaired.

 

On March 10, 2004, our board of directors authorized management,in its discretion, to purchase up to 1,500,000 shares of our common stock overa 24-month period.  Shares may bepurchased in open market transactions, block purchases or privately negotiatedtransactions.  Any repurchased shareswill be held as treasury stock and will be available for general corporatepurposes.  If we repurchase a substantial number of shares during this24-month period, and we do not generate off-setting revenue form our UNIX andSCOsource businesses,  our cash positioncould decrease significantly and our ability to fund future operations could beadversely impacted.  Purchases understock repurchase program are subject to the discretion of management based onmarket conditions and other factors including the trading price of our commonstock, availability of stock, alternative uses of capital and our financialcondition.

 

**ITEM3.****                                                    ****QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

*Foreign Currency Risk. *We have foreign offices and operations in Europe andAsia.  As a result, a portion of ourrevenue is derived from sales to customers outside the United States.  Most of this international revenue isdenominated in U.S. dollars.  However,most of the operating expenses related to our foreign-based operations aredenominated in foreign currencies and therefore operating results are affectedby changes in the U.S. dollar exchange rate in relation to foreign currenciessuch as the Euro, among others.  If theU.S. dollar remains weak compared to the Euro, our operating expenses forforeign operations will be higher when translated back into U.S. dollars.  Our revenue can also be affected by generaleconomic conditions in the United States, Europe and other internationalmarkets.  Our results of operations maybe affected in the short term by fluctuations in foreign currency exchangerates.

 

Weutilize foreign currency forward exchange contracts for market exposures ofunderlying assets and liabilities.  Wedo not use forward exchange contracts for speculative or

 

34

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trading purposes.  Our accounting policies for theseinstruments are based on our designation of such instruments.  The criteria we use for designating aninstrument include the instrument’s effectiveness in risk reduction andone-to-one matching of forward exchange contracts to underlying assets andliabilities.  Gains and losses oncurrency forward contracts that are firm commitments are deferred andrecognized in income in the same period that the underlying transactions aresettled.  Gains and losses on currencyforward contracts that are designated and effective for existing transactionsare recognized in income in the same period as losses and gains on the underlyingtransactions are recognized and generally offset.  Gains and losses on any instruments not meeting the abovecriteria are recognized in income in the current period.  As of January 31, 2004, we had oneforeign exchange contract with a maturity of approximately 30 days to sell anaggregate of 650,000 United Kingdom pounds for approximately $1,170,000 U.S.dollars.  As of January 31, 2004, we had no outstandinginstruments accounted for as hedges.

 

*Interest Rate Risk. *The primary objective ofour cash management strategy is to invest available funds in a manner thatassures maximum safety and liquidity and maximizes yield within suchconstraints.  We do not borrow money forshort-term investment purposes.

 

*Investment Risk. *We have invested in equityinstruments of privately held and public companies in the technology industryfor business and strategic purposes. Investments are accounted for under the cost method if our ownership isless than 20 percent and we are not able to exercise influence over operations.  Our investment policy is to regularly reviewthe assumptions and operating performance of these companies and to recordimpairment losses when events and circumstances indicate that these investmentsmay be impaired.  As of January 31,2004, our investments balance was approximately $488,000.

 

Thestock market in general, and the market for shares of technology companies inparticular, has experienced extreme 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 caused by changesin customer demand may have a significant impact on the market price of ourcommon stock.  These conditions couldcause the price of our common stock to fluctuate substantially over shortperiods of time.

 

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

 

*Evaluation of disclosure controls and procedures.* Under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, we evaluatedthe effectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rule 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934 (the “Exchange Act”)). Based upon that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that, as of the end of the period covered by thisreport, our disclosure controls and procedures were adequately designed toensure that information required to be disclosed by us in the reports we fileor submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in applicable rules and forms.

 

*Changes in internal control over financial reporting.* During the most recent fiscal quarter ended January 31, 2004, therehas been no change in our internal control over financial reporting (as definedin Rule 13a-15(f) and 15d-15(f) under the Exchange Act) that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

35

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#### ***Forward-LookingStatements 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 intention to maintain our level of investment in  and commitment to our UNIX operating systems, including investing in research  and development efforts during fiscal year 2004 to enhance our OpenServer and  UnixWare products;                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | Our belief that the future success of our SCOsource  initiatives will depend on our ability to protect our intellectual property,  our intention to continue to devote resources to our SCOsource initiatives  and our expectation that quarterly legal fees and other SCOsource related  costs for the remaining quarters of fiscal year 2004 will be consistent with  the level of costs incurred in the first quarter of fiscal year 2004,  although legal expenses could increase depending on developments in our  litigation and the occurrence of certain events outside our control or  certain contingent events could require us to pay additional fees to our law  firms; |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | Our intention to continue seeking to enter into  license agreements with UNIX vendors and implementing our worldwide program  offering SCOsource IP licenses to Linux end users;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | Our intention to continue to increase our SCOsource  sales team in fiscal year 2004;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | Our expectation that SCOsource licensing revenue  will increase in future quarters of fiscal year 2004 in the form of vendor  licenses and SCOsource IP licenses;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | Our anticipation that for the remainder of fiscal  year 2004 our UNIX revenue generated in the Americas and the International  divisions will be consistent with or slightly lower than revenue generated in  the first quarter of fiscal year 2004;                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | Our expectation that our UNIX business will continue  to be impacted by competition from Linux;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | Our expectation that the majority of our services  revenue will continue to be derived from UNIX-based products, and that our  future level of services revenue depends in part on our ability to generate  UNIX products revenue from new customers and as well as renew certain annual  support and services agreements with existing UNIX customers;                                                                                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | Our expectation for the remaining quarters of fiscal  year 2004 that our cost of products revenue in dollars will be consistent to  cost of products revenue incurred in the first quarter of fiscal year 2004;                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | Our expectation for the remaining quarters of fiscal  year 2004 that our cost of SCOsource licensing revenue will be consistent  with our cost of SCOsource licensing revenue for the first quarter of fiscal  year 2004, subject to quarter-to-quarter fluctuations based on unpredictable  SCOsource licensing revenue, the possibility that legal expenses could  increase depending on developments in our litigation,  and the occurrence of certain events  outside our control or certain contingent eventscould require us to pay an  additional contingency fee to our law firms;                                                                                      |

 

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| • |   | Our expectation for the remaining quarters of fiscal  year 2004 that our cost of services revenue in dollars will be slightly less  than in the first quarter of fiscal year 2004;                                                                                                                                                                                                                                                                                                                                                                                            |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| • |   | Our expectation for the remaining quarters of fiscal  year 2004 that our sales and marketing expenses in dollars will decrease from  our expenses incurred in the first quarter of fiscal year 2004;                                                                                                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| • |   | Our expectation for the remaining quarters of fiscal  year 2004 that our research and development expenses in dollars will remain  consistent or increase slightly from our expenses incurred in the first  quarter of fiscal year 2004;                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| • |   | Our expectation for the remaining quarters of fiscal  year 2004 that our general and administrative expenses in dollars will  decrease compared to our general and administrative expenses incurred in the  first quarter of fiscal year 2004;                                                                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| • |   | Our belief that we have sufficient cash resources to  fund our current operations for at least the next 12 months;                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| • |   | Our belief that our allowance and bad debts for  accounts receivable will remain consistent with our prior experience;                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| • |   | Our belief that our legal costs for the remaining  quarters of fiscal year 2004 will remain consistent with those incurred in  the first quarter of fiscal year 2004,   although legal expenses could increase depending on developments in  our litigation and the occurrence of certain events outside our control or  certain contingent events could require us to pay additional fees to our law  firms;                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| • |   | Our anticipation of recording other income in the  second quarter of fiscal year 2004 related to the change in the fair value of  the derivative between January 31, 2004 and February 5, 2004, the  time at which the exchange agreement was executed and recording a dividend in  the second quarter of fiscal year 2004 related to the difference between the  fair value of the new redeemable Series A-1 Convertible Preferred Stock and  the carrying value of the previously issued redeemable Series A Convertible  Preferred Stock and related derivative; |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| • |   | Our belief that certain legal actions to which we  are a party will not have a material adverse effect on us; and                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| • |   | Our announced plan to repurchase up to 1,500,000  shares of our common stock.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |

 

We wish to cautionreaders that our operating results are subject to various risks anduncertainties that could cause our actual results and outcomes to differmaterially from those discussed or anticipated, including the success of ourSCOsource initiatives, competition from other operating systems, particularlyLinux, the amount and timing of SCOsource licensing revenue, our ability toenhance our UNIX operating systems and maintain our UNIX products and servicesbusiness, and the factors set forth in the subsection entitled “RiskFactors” below.  We also wish to advisereaders not to place any undue reliance on the forward-looking statementscontained in this report, which reflect our beliefs and expectations only as ofthe date of this report.  We assume noobligation to update or revise these forward-looking statements to reflect newevents or circumstances or any changes in our beliefs or expectations, otherthan as required by law.

 

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

#### *** ***

*We do not have a history of profitableoperations.*

 

Our fiscal year ended October 31,2003 was the first full year we were profitable in our operating history.  Our profitability in fiscal year 2003resulted primarily from our SCOsource licensing initiatives.  For the three months ended January 31,2004, we incurred a net loss of $1,497,000 and our accumulated deficit as ofJanuary 31, 2004 was approximately $202,363,000.  If we do not receive SCOsource licensing revenue in futurequarters and our revenue from the sale of our UNIX operating system platformproducts and services continues to decline, we will need to further reduceoperating expenses to maintain profitability or generate positive cash flow.

 

Our UNIX products andservices revenue has declined in each of the last four years primarily as a result of increased competition from alternativeoperating systems, particularly Linux, lower information technology spendingand the general economic slowdown.  In ourquarterly results of operations, we recognize revenue from agreements forsupport and maintenance contracts and other long-term contracts that have beenpreviously invoiced and are included in deferred revenue.  Our deferred revenue balance increased from$5,501,000 as of October 31, 2003 to $6,952,000 as of January 31, 2004,however, this increase in deferred revenue may not continue into futurequarters, which may have a negative impact on our operating system platformproducts revenue.  Our future operatingsystem platform revenue may be adversely impacted and may continue to declineif we are unable to replenish these deferred revenue balances with long-termmaintenance and support contracts or replace them with other sustainablerevenue streams.  If we are unable tocontinue to generate positive cash flow and profitable operations, ouroperations may be adversely impacted.

 

Additionally, weaccounted for the issuance of our redeemable Series A Convertible PreferredStock from our October 2003 private placement by bifurcating the value ofthe redeemable Series A Convertible Preferred Stock into a preferred stockcomponent and a derivative component. As of October 31, 2003, the fair value of the derivative was$15,224,000 and the decrease in fair value of $2,845,000 was recorded as otherincome in the statement of operations for fiscal year 2003.  As of January 31, 2004, we recorded aliability of $11,600,000 as the fair value of the derivative component.  In addition, for the three months endedJanuary 31, 2004, we recorded a charge of $3,624,000 to other incomerelated to the change in the fair value of the derivative component.  The derivative was eliminated due to certainrights and privileges  included in thenew redeemable Series A-1 Convertible Preferred Stock such as voting rights andrights to board representation, among others, that were not included in theredeemable Series A Convertible Preferred Stock.

 

On February 5, 2004, we completed an exchange transaction in whicheach outstanding share of redeemable Series A Convertible Preferred Stock wasexchanged for one share of our new redeemable Series A-1 Convertible PreferredStock. The exchange transaction eliminated the derivative related to theredeemable Series A Convertible Preferred Stock that was initially recorded asa current liability on our balance sheet and eliminates the charge in ourquarterly statements of operations for the change in the fair value of thederivative related to the redeemable Series A Convertible Preferred Stock.  We anticipate recording other income in thesecond quarter of fiscal year 2004 related to the change in the fair value of thederivative between January 31, 2004 and February 5, 2004, the time atwhich our exchange agreement was executed. We also anticipate recording a dividend in the second quarter of fiscalyear 2004 related to the difference between the fair value of the newredeemable Series A-1 Convertible Preferred Stock and the carrying value of thepreviously issued redeemable Series A Convertible Preferred Stock and relatedderivative.  This dividend will reduceearnings to common stockholders.

 

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*Our future SCOsource licensing revenue isuncertain.*

 

We initiated theSCOsource licensing effort in January 2003 to review the status of UNIXlicensing and sublicensing agreements. This effort resulted in the execution oftwo significant vendor license agreements during the fiscal year 2003 andgenerated $25,846,000 in revenue. During the three months ended January 31, 2004, we recordedSCOsource licensing revenue of $20,000 related to the execution of intellectualproperty compliance licenses.  Due to alack of historical experience and the uncertainties related to SCOsourcelicensing revenue, we are unable to estimate the amount and timing of futureSCOsource licensing revenue, if any.  Ifwe do receive revenue from this source, it may be sporadic and fluctuate fromquarter to quarter.  Our SCOsourceinitiatives are unlikely to produce stable, predictable revenue for theforeseeable future.  Additionally, thesuccess of these initiatives may depend on the strength of our intellectualproperty rights and contractual claims regarding UNIX, including, the strengthof our claim that unauthorized UNIX source code and derivatives are prevalentin Linux.

 

*We may not prevail in our legal actionsagainst IBM, Novell and end users, and unintended consequences of our actionsagainst IBM, Novell and end users and other initiatives to assert ourintellectual property rights may adversely affect our business.*

 

On or about March 6, 2003, we filed a complaint against IBMalleging breach of contract, misappropriation of trade secrets, tortiousinterference, and unfair competition. The matter is currently pending in theUnited States District Court for the District of Utah. The complaint alsoalleges that IBM obtained information concerning our UNIX source code andderivative works from us and inappropriately used and distributed thatinformation in connection with its efforts to promote the Linux operatingsystem.

 

On or about June 16, 2003, we filed an amended complaint in theIBM case. The amended complaint essentially restates and realleges theallegations of the original complaint and expands on those claims in severalways. Most importantly, the amended complaint raises new allegations regardingIBM’s actions and breaches through the products and services of Sequent, whichIBM acquired. We allege that IBM breached the Sequent agreement in several wayssimilar to those set forth above, and we are seeking damages flowing from thosebreaches. We are also seeking injunctive relief on several of our claims.

 

IBM has filed a response and counterclaim to the complaint, including ademand for jury trial. We have filed an answer to the IBM counterclaim denyingthe claims and asserting affirmative defenses.

 

In its counterclaim, as amended on September 25, 2003, IBM assertsthat we do not have the right to terminate its UNIX license or assert claimsbased on our ownership of UNIX intellectual property against them or others inthe Linux community. In addition, they assert that we have infringed on certainpatents held by IBM. IBM’s counterclaims include claims for breach of contract,violation of the Lanham Act, unfair competition, intentional interference withprospective economic relations, unfair and deceptive trade practices, breach ofthe GNU general public license, and patent infringement. Discovery and relateddiscovery motions are ongoing in the case. We intend to vigorously defend thesecounterclaims. On February 4, 2004, we filed a motion for leave to fileamended pleadings in the case proposing to amend our complaint against IBM andto modify our affirmative defenses against IBM’s counterclaims.  OnFebruary 25, 2004, the court granted our motion for leave.  The second amended complaint, which wasfiled on February 27, 2004, alleges nine causes of action that are similarto those set forth above, adds a new claim for copyright infringement andremoves the claim for misappropriation of trade secrets.  IBM has not yet responded to the secondamended complaint.

 

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If we do not prevail in our action against IBM, or if IBM is successfulin its counterclaim against us, our business and results of operations could bematerially harmed. The litigation with IBM and potentially others could becostly, and our costs for legal fees may be substantial and in excess ofamounts for which we have budgeted. Additionally, the market price of ourcommon stock may be negatively affected as a result of developments in ourlegal action against IBM that may be, or may be perceived to be, adverse to us.

 

In addition, we have publicly, and in individual letters to 1,500 ofthe world’s largest corporations, cautioned users of Linux that there areunresolved intellectual property issues surrounding Linux that may expose them tounanticipated liability. As a result of these concerns, we have suspended oursales of Linux products. We have also begun delivering written notice to alarge number of licensees under our UNIX contracts requiring them to, amongother things, provide written certification that they are in full compliancewith their agreements, including certification that they are not using ourproprietary UNIX code in Linux, have not allowed unauthorized use of licensedUNIX code by their employees or contractors and have not breachedconfidentiality provisions relating to licensed UNIX code. Additionally, wehave begun notifying selected Linux end users in writing of violations weallege under the Digital Millennium Copyright Act related to our copyrightscontained in Linux.

 

As a result of our action against IBM and our SCOsource initiatives toprotect our intellectual property rights, several participants in the Linuxindustry and others affiliated with IBM or sympathetic to the Linux movementhave taken actions attempting to negatively affect our business and ourSCOsource efforts. Linux proponents have taken a broad range of actions againstus, including, for example, attempting to influence participants in the marketsin which we sell our products to reduce or eliminate the amount of our productsand services they purchase from us. We expect that similar efforts likely willcontinue. There is a risk that participants in our marketplace will negativelyview our action against IBM and our SCOsource initiatives, and we may losesupport from such participants.

 

Any of the foregoing could adversely affect our position in themarketplace, our results of operations and our stock price.

 

We have also experienced several denial-of-service attacks on ourwebsite, which have prevented web users from accessing our website and doingbusiness with us for a period of time. If such attacks continue or if ourcustomers and strategic partners are also subjected to similar attacks, ourbusiness and results of operations could be materially harmed.

 

Also, some of the more significant participants in the Linux industryhave made efforts to ease Linux end users’ concerns that their use of Linux maysubject them to potential copyright infringement claims from us. For example,Hewlett-Packard, Novell and Red Hat have each established indemnificationprograms for qualified customers purchasing Linux-based products and servicesthat may potentially become subject to a copyright infringement claims from us.Additionally, Open Source Development Labs, a non-profit organization (“OSDL”),has established a legal defense fund that will be used to defend Linux usersagainst copyright infringement lawsuits brought by us. It has been reportedthat OSDL so far has attracted several million dollars in pledges fromcontributors including IBM and Intel among others. Similarly, RedHat, Inc. has announced it has committed one million dollars for aseparate fund it created to cover the legal expenses of other companiesdeveloping Linux.

 

As a further response to our SCOsource initiatives and claim that ourUNIX source code and derivative works have inappropriately been included inLinux, Novell has publicly asserted its belief that it owns certain copyrightsin our UNIX source code, and it has filed 15 copyright applications with theUnited States Copyright Office related to UNIX. Novell also claims that it hasa license to UNIX from us and the right to authorize its customers to use UNIXtechnology in their

 

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internal business operations. Specifically, Novell has also claimed tohave retained rights related to legacy UNIX SVRx licenses, including thelicense with IBM. Novell asserts it has the right to take action on behalf ofSCO in connection with such licenses, including termination rights. Novell haspurported to veto our termination of the IBM, Sequent and SGI licenses. We haverepeatedly asserted that we obtained the UNIX business, source code, claims andcopyrights when we acquired the assets and operations of the server andprofessional services groups from The Santa Cruz Operation in May 2001,which had previously acquired all such assets and rights from Novell inSeptember 1995 pursuant to an asset purchase agreement, as amended.

 

On January 20, 2004, in response to Novell’s actions, we broughtsuit against Novell for slander of title seeking relief for Novell’s allegedbad faith effort to interfere with our copyrights related to our UNIX sourcecode and derivative works and our UnixWare products.  The case is currently pending before the Third Judicial DistrictCourt in Salt Lake City, Utah. Novell has not yet answered to our complaint buthas filed with the United States District Court for the District of Utah anotice removing the case to such federal court and a motion with the ThirdJudicial District Court in Salt Lake County, Utah to transfer the venue of thecase from such court to the Fourth Judicial District Court in Utah County,Utah. Neither court has ruled on these actions. Novell also filed a motion todismiss our complaint claiming it never transferred the copyrights to The SantaCruz Operation. We have filed a response to Novell’s motion to dismiss and havealso filed a motion to remand the case back to the state court.  The court has not ruled on thesemotions.  We plan to vigorously pursueits claims against Novell.

 

Among our allegations in the suit against Novell, we allege that Novellhas improperly filed copyright registrations in the United States CopyrightOffice for UNIX technology covered by our copyrights and has made false andmisleading public claims that it, and not our company, owns the UNIX andUnixWare copyrights. We also allege that Novell has made false statements withthe intent to cause customers and potential customers to not do business withus and has attempted, in bad faith, to block our ability to enforce ourcopyrights. Additionally, we allege that Novell’s false and misleadingrepresentations that it owns the UNIX and UnixWare copyrights have caused usirreparable harm to our copyrights, our business, and our reputation.

 

In the lawsuit, we request preliminary and permanent injunctive reliefas well as damages. The injunction would require Novell to assign to us allcopyrights that we believe Novell has wrongfully registered, prevent Novellfrom representing any ownership interest in those copyrights, and requireNovell to retract or withdraw all representations it has made regarding itspurported ownership of those copyrights.

 

On or about March 2, 2004, we brought suit against AutoZone, Inc.(“AutoZone”) for its alleged violations of our UNIX copyrights through its useof Linux.  Specifically, the lawsuitalleges that AutoZone violated our UNIX copyrights by running versions of theLinux operating system that contain code, structure, sequence and/ororganization from our proprietary UNIX System V code in violation of ourcopyrights.  The lawsuit filed in U.S.District Court in Nevada requests injunctive relief against AutoZone’s furtheruse or copying of any part of our copyrighted materials and also requestsdamages as a result of AutoZone’s infringement in an amount to be proven attrial.

 

On or about March 3, 2004, we brought suit against DaimlerChryslerCorporation (“DaimlerChrysler”) for its alleged violations of its UNIX softwareagreement with us.  Specifically, thelawsuit alleges that DaimlerChrysler breached its UNIX software agreement withus by failing to certify by January 31, 2004 its compliance with the UNIXsoftware agreement as required by us. The lawsuit, filed in Oakland County Circuit Court in the State ofMichigan, requests the court to issue orders declaring that DaimlerChrysler hasviolated the certification requirements of its UNIX software agreement,permanently enjoin DaimlerChrysler from further violations of the UNIX softwareagreement, issue a mandatory injunction requiring DaimlerChrysler to remedy theeffects

 

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of its past violations of the UNIX software agreement and award usdamages in amount to be determined at trial together with costs, attorneys’fees and any such other or different relief that the Court may deem to beequitable and just.

 

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

 

*We may lose the support of industry partnersleading to an accelerated decline in our UNIX products and services revenue.*

 

Our SCOsource initiatives, particularly lawsuits against end usersviolating our intellectual property and contractual rights, 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 anaccelerated decline in our UNIX products and services revenue and wouldadversely impact our results of operations and liquidity.

 

*Our claims relating to our UNIX intellectualproperty may subject us to additional legal proceedings.*

 

On or about August 4, 2003, Red Hat filed a complaint against usthat is currently pending in the United States District Court for the Districtof Delaware. Red Hat has asserted that the Linux operating system does notinfringe on our UNIX intellectual property rights and seeks a declaratoryjudgment for non-infringement of copyrights and no misappropriation of tradesecrets. In addition, Red Hat claims we have engaged in false advertising inviolation of the Lanham Act, deceptive trade practices, unfair competition,tortious interference with prospective business opportunities, and trade libeland disparagement. We have filed a motion to dismiss the Red Hat complaint,asserting that Red Hat lacks standing and that no case or controversy exists onwhich to base a declaratory judgment. Red Hat has filed an opposition to ourmotion to dismiss, but the court has not ruled on the motion. If Red Hat issuccessful in its claim against us, our business and results of operationscould be materially harmed.

 

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

 

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Several entities in Germany have obtained temporary restraining ordersin Germany precluding our German subsidiary, from making statements in Germanythat, in substance, disparage Linux, or entities involved in the Linuxindustry, or implicate Linux as infringing our intellectual property rights.SCO GmbH has received an administrative fine of 10,000 Euros for a technicalviolation of one of the temporary restraining orders. We are currentlynegotiating with the various claimants in Germany over the temporaryrestraining orders and our options regarding these matters. Informal complaintssimilar to those raised in Germany have been received from companies in Austriaand Poland. We have responded to those complaints. It is not known if thosecomplainants will take future action.

 

In addition to these above-mentioned actions, other regulators orothers in the Linux community may initiate legal actions against us, all ofwhich may negatively impact our operations or future operating performance.

 

*Fluctuations in our operating results or thefailure of our operating results to meet the expectations of public marketanalysts and investors may negatively impact our stock price.*

 

Fluctuations in our quarterly operating results or our failure to meetthe expectations of analysts or investors, even in the short-term, could causeour stock price to decline significantly. Because of the potential forsignificant fluctuations in our SCOsource licensing revenue in any particularperiod, you should not rely on quarter-to-quarter comparisons of our results ofoperations as an indication of future performance.

 

Factors that may affect our results include:

 
| • |   | our ability to successfully negotiate and complete licensing and  other agreements related to our intellectual property;                                                                                                                             |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                 |
| • |   | the interest level of resellers in recommending our UNIX business  solutions to end users;                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                 |
| • |   | the introduction, development, timing, competitive pricing and market  acceptance of our products and services and those of our competitors;                                                                                                         |
|   |   |                                                                                                                                                                                                                                                 |
| • |   | changes in general economic conditions, such as recessions, that  could affect capital expenditures and recruiting efforts in the software  industry;                                                                                                |
|   |   |                                                                                                                                                                                                                                                 |
| • |   | changes to, or developments in, our ongoing litigation with IBM,  Novell, Red Hat, AutoZone and DaimlerChrysler concerning our UNIX  intellectual property;                                                                                          |
|   |   |                                                                                                                                                                                                                                                 |
| • |   | changes in business attitudes toward UNIX as a viable operating  system compared to other competing systems, especially Linux;                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                 |
| • |   | the contingency fees we may pay to the law firms representing us in  our efforts to establish our intellectual property rights; and                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                 |
| • |   | changes in attitudes of customers and partners due to our aggressive  position against the inclusion of our UNIX code and derivative works in Linux  and our lawsuits against end users violating our intellectual property and  contractual rights. |

 

We also experience fluctuations in operating results in interim periodsin Europe and the Asia Pacific regions due to seasonal slowdowns and economicconditions in these areas. Seasonal slowdowns in these regions typically occurduring the summer months.

 

As a result of the factors listed above and elsewhere, it is possiblethat our results of operations may be below the expectations of public marketanalysts and investors in any particular

 

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period. This could cause our stock price to decline. If revenue fallsbelow our expectations and we are unable to quickly reduce our spending inresponse, our operating results will be lower than expected. Our stock pricemay fall in response to these events.

 

*We rely on our indirect sales channel fordistribution of our products, and any disruption of our channel at any levelcould adversely affect the sales of our products.*

 

We have a two-tiered distribution channel. The relationships we havedeveloped with resellers allow us to offer our products and services to a muchlarger customer base than we would otherwise be able to reach through our owndirect sales and marketing efforts. Some solution providers also purchasesolutions through our resellers, and we anticipate they will continue to do so.Because we usually sell indirectly through resellers, we cannot control therelationships through which resellers, solution providers or equipmentintegrators purchase our products. In turn, we do not control the presentationof our products to end-users. Therefore, our sales could be affected bydisruptions in the relationships between us and our resellers, between ourresellers and solution providers, or between solution providers and end users.Also, resellers and solution providers may choose not to emphasize our productsto their customers. Any of these occurrences could diminish the effectivenessof our distribution channel and lead to decreased sales.

 

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

 

Our revenue from the sale of UNIX-based products has declined over thelast four years. This decrease in revenue has been attributable primarily toincreased competition from other operating systems, particularly Linux, lowerinformation technology spending and the worldwide economic slowdown. If thedemand for UNIX-based products continues to decline, and we are unable todevelop UNIX products and services that successfully address a market demand,our business will be adversely affected. Because of the long adoption cycle foroperating system purchases and the long sales cycle of our operating systemproducts, we may not be able to reverse these revenue declines quickly.

 

*We operate in a highly competitive market andface significant competition from a variety of current and potential sources;many of our current and potential competitors have greater financial andtechnical resources than we do; thus, we may fail to compete effectively.*

 

In the UNIX operating system market, our competitors include IBM,Hewlett-Packard, Sun, Microsoft and Linux distributors. These and othercompetitors are aggressively pursuing the current UNIX operating system market.Many of these competitors have access to substantially greater resources thanwe do. The major competitive alternatives to our UNIX products are MicrosoftWindows Server, Linux and other UNIX systems. The expansion of Microsoft’s andour other competitors’ offerings may restrict the overall market available forour server products, including some markets where we have been successful inthe past.

 

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

 

The success of our UNIX business will depend on the level of commitmentand certification we receive from industry partners and developers. In recentyears, we have seen hardware and

 

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software vendors as well as software developers turn theircertification and application development efforts toward Linux and elect not tocontinue to support or certify to our UNIX operating system products. If thistrend continues, our competitive position will be adversely impacted and ourfuture revenue from our UNIX business will decline. The decline in our UNIXbusiness may be accelerated if industry partners withdraw their support from usas a result of our SCOsource initiatives and in particular any lawsuit againstend users violating our intellectual property and contractual rights, such asour lawsuits against AutoZone and DaimlerChrysler.

 

*Our compensation arrangement with the lawfirms representing us to enforce our intellectual property rights may reduceour ability to raise additional financing.*

 

Our compensation arrangement with the law firms representing us in ourefforts to establish our intellectual property rights could inhibit our abilityto raise additional funding if needed. In addition to receiving fees at reducedhourly rates, our agreement with the law firms provides that the law firms willreceive a contingency fee of 20 percent of the proceeds from specifiedevents related to the protection of our intellectual property rights. Theseevents may include settlements, judgments, certain licensing fees, subject tocertain exceptions, and a sale of our company during the pendancy of litigationor through settlement, subject to agreed upon credits for amounts received asdiscounted hourly fees and unused retainer fees, and our agreement with the lawfirms may also be construed to include contingency fee payments in connectionwith issuances of our equity securities. Future payments payable to the lawfirms under this arrangement may be significant. Our law firms’ right toreceive such contingent payments could cause prospective investors to choosenot to invest in our company or limit the price at which new investors would bewilling to provide additional funds to our company.

 

*Our foreign-based operations and sales createspecial problems, including the imposition of governmental controls andfluctuations in currency exchange rates that could hurt our results.*

 

We have foreign operations, including development facilities, salespersonnel and customer support operations in Europe, Latin America and Asia.These foreign operations are subject to certain inherent risks, including:

 
| • |   | potential loss of developed technology through piracy,  misappropriation, or more lenient laws regarding intellectual property  protection; |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                        |
| • |   | imposition of governmental controls, including trade restrictions and  other tax requirements;                                              |
|   |   |                                                                                                                                        |
| • |   | fluctuations in currency exchange rates and economic instability;                                                                           |
|   |   |                                                                                                                                        |
| • |   | longer payment cycles for sales in foreign countries;                                                                                       |
|   |   |                                                                                                                                        |
| • |   | seasonal reductions in business activity; and                                                                                               |
|   |   |                                                                                                                                        |
| • |   | political unrest, particularly in areas where we have facilities.                                                                           |

 

In addition, 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.

 

In Latin America and Asia in particular, several countries havesuffered and may be especially susceptible to recessions and economicinstability which may lead to increased governmental ownership or regulation ofthe economy, higher interest rates, increased barriers to entry such as highertariffs and taxes, and reduced demand for goods manufactured in the UnitedStates, resulting in lower revenue.

 

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*The impact of domestic and global economicconditions may continue to adversely impact our operations.*

 

During the last several quarters the U.S. and European economies haveexperienced an economic slowdown that has affected the purchasing habits ofmany consumers across many industries and across many geographies. This hascaused the delay, or even cancellation of technology purchases. The slowdown inthe United States and Europe, together with the alleged unauthorized use of ourUNIX code, has resulted in decreased sales of our products, longer sales cyclesand lower prices. If the current slowdown continues, our revenue and results ofoperations may continue to be lower than expected. In addition, the slowdownmay also affect the end-user market making it more difficult for our resellerchannel to sell our products.

 

*If we are unable to retain key personnel inan intensely competitive environment, our operations could be adverselyaffected.*

 

We will need to retain our management, technical, and supportpersonnel. Competition for qualified professionals in the software industry isintense, and departures of existing personnel could be disruptive to ourbusiness and can result in the departure of other employees. The loss ordeparture of any officers or key employees could harm our ability to implementour business plan and could adversely affect our operations. Our future successdepends to a significant extent on the continued service and coordination ofour management team, particularly Darl C. McBride, our President and ChiefExecutive Officer. We do not maintain key person insurance for any member ofour management team.

 

*Ourstock price is volatile.*

 

The trading price for ourcommon stock has been volatile, ranging from a low closing sales price of $1.09in mid-February 2003, to a sales price of $20.50 per share inOctober 2003, to a current sales price of $9.51 on March 10, 2004.The share price has changed dramatically over short periods with increases anddecreases of over 25 percent in a single day. We believe that the changes in our stock price are affected by changingpublic perceptions concerning the strength of our intellectual property claimsand other factors beyond our control. Public perception can change quickly and without any change ordevelopment in our underlying business or litigation position.  An investment in our stock is subject tosuch volatility and, consequently, is subject to significant risk.

 

*Risks associated with the potential exerciseof our options outstanding.*

 

As of March 1, 2004, we have issued and outstanding options topurchase up to approximately 3,438,000 shares of common stock with exerciseprices ranging from $0.66 to $28.00 per share. 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 willdilute the percentage ownership interest of our stockholders and may dilute thevalue of their ownership. The possible future sale of shares issuable on theexercise of outstanding options could adversely affect the prevailing marketprice for our common stock. Further, the holders of the outstanding rights mayexercise them at a time when we would otherwise be able to obtain additionalequity capital on terms more favorable to us.

 

*The holders of shares of redeemable SeriesA-1 Convertible Preferred Stock have preferential redemption rights and rightsupon liquidation that could adversely affect the holders of our common stock.*

 

On October 16, 2003, we completed a $50,000,000 private placementof 50,000 shares of our redeemable Series A Convertible Preferred Stock andreceived net proceeds of approximately $47,740,000.  On February 5, 2004, we completed an exchange transaction inwhich each outstanding share of redeemable Series A Convertible Preferred Stockwas exchanged for one share of our new redeemable Series A-1 ConvertiblePreferred Stock.

 

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If the holders of shares of redeemable Series A-1 Convertible PreferredStock choose not to convert their shares, then,  they will be entitled to require us to repurchase for cash allthe shares of redeemable Series A-1 Convertible Preferred Stock held by them ata premium price if any of several redemption trigger events occurs.  These redemption provisions, if triggered,would require us to redeem the then-issued and outstanding shares of ourredeemable Series A-1 Convertible Preferred Stock for cash.

 

Additionally, the Certificate of Designation for the redeemable SeriesA-1 Convertible Preferred Stock provides that the number of shares of ourcommon stock issuable upon the conversion of shares of redeemable Series A-1Convertible Preferred Stock is limited to 2,863,135 shares in the aggregate,notwithstanding that the holders of shares of redeemable Series A-1 ConvertiblePreferred Stock may otherwise be entitled to receive more shares of commonstock upon conversion based on the applicable conversion price. If the numberof shares of common stock issuable to the holders of shares of redeemableSeries A-1 Convertible Preferred Stock upon conversion is limited in thismanner, then we may be required by the holders of such shares to redeem forcash the number of shares of redeemable Series A-1 Convertible Preferred Stockthat were not issuable upon conversion as a result of such limits onconversion. If we were required to pay cash to the holders of shares of ourredeemable Series A-1 Convertible Preferred Stock for any reason, it could havea material impact on our liquidity, which may require us to obtain additionalsources of cash to sustain operations and may negatively impact the holders ofour common stock.

 

Further, the holders of shares of our redeemable Series A-1 ConvertiblePreferred Stock will be entitled to receive a preferential distribution of ourassets prior to any distribution to our holders of common stock upon aliquidation, dissolution, winding up or other change in control transaction inwhich we sell all or substantially all our assets or merge or consolidate orotherwise combine with another company or entity. Upon the occurrence of aliquidation event, the holders of redeemable Series A-1 Convertible PreferredStock will be entitled to receive the greater of:

 
| • |   | the value of the shares of redeemable Series A-1 Convertible  Preferred Stock held by them determined by multiplying the closing sale price  of our common stock on the Nasdaq SmallCap Market on the date of the  liquidation event by the number of shares of common stock into which the  preferred shares could be converted at the time of the liquidation event; or |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| • |   | up to $50,000,000, the aggregate purchase price paid by the investors  in our October 2003 redeemable Series A Convertible Preferred Stock  private placement, plus eight percent of that amount less the amount of any  dividends paid to the preferred stockholders in the calendar year in which  the liquidation event occurs.                                   |

 

Depending on the amount of assets we have available for distribution tostockholders upon a liquidation event when shares of redeemable Series A-1Convertible Preferred Stock remain outstanding, we may be required todistribute all such assets or a portion of such assets that exceeds thepreferred stockholders’ pro rata ownership of our common stock assuming fullconversion of their preferred shares into common stock, which could eliminateor limit the assets available for distribution to our common stockholders. Ourpotential obligation to pay to the law firms representing us in our efforts toestablish our intellectual property rights a contingent fee of 20 percentof the proceeds we receive from a sale of our company, subject to certainlimitations, could also contribute to eliminating or limiting the assetsavailable for distribution to our common stockholders.

 

*The rights of holders of shares of redeemableSeries A-1 Convertible Preferred Stock may prevent or make it more difficultfor us to raise additional funds or take other significant company actions.*

 

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The Certificate of Designation creating our redeemable Series A-1Convertible Preferred Stock requires us to obtain the approval of the holdersof a majority of the then outstanding redeemable Series A-1 ConvertiblePreferred Stock to take the following actions, among others:

 
| • |   | change the rights, preferences or privileges of the redeemable Series  A-1 Convertible Preferred Stock or issue additional shares of redeemable  Series A-1 Convertible Preferred Stock;                                                                                                                                       |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                           |
| • |   | create or issue any other securities that are senior or equal in rank  to the redeemable Series A-1 Convertible Preferred Stock;                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| • |   | create or issue any convertible securities having floating conversion  rate terms or a fixed conversion price below the then applicable conversion  price of the redeemable Series A-1 Convertible Preferred Stock or the closing  sale price of our common stock on the Nasdaq SmallCap Market on the date of  such issuance; |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| • |   | incur any indebtedness, subject to limited exceptions; or                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| • |   | sell or transfer any material asset or intellectual property to a  third party.                                                                                                                                                                                                                                                |

 

The Certificate of Designation also provides that the holders of ourredeemable Series A-1 Convertible Preferred Stock have a participation rightentitling them to purchase their pro rata share of any future equitysecurities, or debt that is convertible into equity, on the same terms offeredby us to other purchasers of such securities. Additionally, we have agreed withthe holders of our redeemable Series A-1 Convertible Preferred Stock that wewill not complete a transaction or take any action that could result in a claimfor a contingency payment by the law firms representing us in our efforts toestablish our intellectual property rights, other than contingency paymentsrelated to certain license transactions, without first obtaining the consent ofthe investors holding at least two thirds of the shares of our redeemableSeries A-1 Convertible Preferred Stock. This right of consent, and theparticipation right and other approval rights described above, may make it moredifficult for management, our board of directors or our stockholders to reach asettlement in our litigation with IBM, raise capital in the future in eitherequity or debt financing transactions or to take other significant companyactions. These provisions could also limit the price that some investors mightbe willing to pay for shares of our common stock in the future.

 

*The shares of redeemable Series A-1Convertible Preferred Stock may have an adverse impact on the market value ofour stock and the existing holders of our common stock.*

 

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

 

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conversion price of the redeemable Series A-1 Convertible PreferredStock decreases, the potential adverse dilution for our holders of common stockwill increase. The market price of our common stock also could decline as aresult of the perception or expectation that sales of a large number of sharesof our common stock could occur following the conversion of our redeemableSeries A-1 Convertible Preferred Stock.

 

*The right of our board of directors toauthorize additional shares of preferred stock could adversely impact therights of holders of our common stock.*

 

Our board of directors currently has the right, with respect to the4,840,000 shares of our preferred stock not designated as either 80,000 sharesof redeemable Series A Convertible Preferred Stock or 80,000 shares ofredeemable Series A-1 Convertible Preferred Stock, to authorize the issuance ofone or more additional series of our preferred stock with such voting, dividendand other rights as our directors determine. We further anticipate that we willterminate the redeemable Series A Convertible Preferred Stock, which, upon suchtermination, will cause the number of shares of preferred stock not designatedto increase to 4,920,000 shares. The board of directors can designate newseries of preferred stock without the approval of the holders of our commonstock, subject to the approval rights of our holders of redeemable Series A-1Convertible Preferred Stock as described above. The rights of holders of our commonstock may be adversely affected by the rights of any holders of additionalshares of preferred stock that may be issued in the future, including withoutlimitation, further dilution of the equity ownership percentage of our holdersof common stock and their voting power if we issue preferred stock with votingrights. Additionally, the issuance of preferred stock could make it moredifficult for a third party to acquire a majority of our outstanding votingstock.

 

**PARTII.****                                               ****OTHERINFORMATION**

 

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

 

*IBM Corporation*

 

On or about March 6, 2003, we filed a complaint against IBM. Thisaction is currently pending in the United States District Court for theDistrict of Utah, under the title *The SCOGroup, Inc. vs. International Business Machines Corporation*, CivilNo. 2:03CV0294.  The complaint includesclaims for breach of contract, misappropriation of trade secrets, tortiousinterference, and unfair competition. The complaint also alleges that IBMobtained information concerning the UNIX source code and derivative works fromus and inappropriately used and distributed that information in connection withits efforts to promote the Linux operating system.  As a result of IBM’s breach of contract and unfair competitionand the marketplace injury sustained by us, we are requesting damages in anamount to be proven at trial, but no less than $1 billion, together withadditional damages through and after the time of trial. On or aboutJune 13, 2003, we delivered to IBM a notice of termination of IBM’s UNIXlicense agreement with us that underlies IBM’s AIX software.

 

On or about June 16, 2003, we filed an amended complaint in theIBM case. The amended complaint essentially restates and re-alleges theallegations of the original complaint and expands on those claims in severalways.  Most importantly, the amendedcomplaint raises new allegations regarding IBM’s actions and breaches throughthe products and services of Sequent Computer Systems, Inc. (“Sequent”), whichIBM acquired.  We allege that IBMbreached the Sequent agreement in several ways similar to those set forth aboveand we seek damages for those breaches. We are also seeking injunctive relief on several claims.

 

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IBM has filed a response and counterclaim to the complaint, including ademand for a jury trial.  We have filedan answer to the IBM counterclaim denying the claims and asserting affirmativedefenses.

 

In its counterclaim, asamended on September 25, 2003, IBM asserts that we do not have the rightto terminate its UNIX license or assert claims based on our ownership of UNIXintellectual property against them or others in the Linux community.  In addition, IBM asserts we have breachedthe GNU General Public License and have infringed certain patents held by IBM.IBM’s counterclaims include claims for breach of contract, violation of theLanham Act, unfair competition, intentional interference with prospectiveeconomic relations, unfair and deceptive trade practices, promissory estoppel,copyright infringement and patent infringement.  Discovery is ongoing in the case. We intend to vigorously defendthese counterclaims.

 

On February 4, 2004,we filed a motion for leave to file amended pleadings in the case proposing toamend our complaint against IBM and to modify our affirmative defenses againstIBM’s counterclaims.  On February 25, 2004, the court granted our motion for leave.  The second amended complaint, which wasfiled on February 27, 2004, alleges nine causes of action that are similarto those set forth above, adds a new claim for copyright infringement andremoves the claim for misappropriation of trade secrets.  IBM has not yet responded to the secondamended complaint.

 

*RedHat, Inc.*

 

On August 4, 2003,Red Hat filed a complaint against us. The action is currently pending in theUnited States District Court for the District of Delaware under the casecaption *Red Hat, Inc. v. The SCO Group, Inc.*,Civil No 03–772.  Red Hat asserts thatthe Linux operating system does not infringe our UNIX intellectual propertyrights and seeks a declaratory judgment for non-infringement of copyrights andno misappropriation of trade secrets. In addition, Red Hat claims we have engaged in false advertising inviolation of the Lanham Act, deceptive trade practices, unfair competition,tortious interference with prospective business opportunities, trade libel, anddisparagement.

 

On or about September 15, 2003, we filed a motion to dismiss theRed Hat complaint.  The motion todismiss asserts that Red Hat lacks standing and that no case or controversyexists with respect to the claims seeking a declaratory judgment ofnon-infringement.  The motion to dismissfurther asserts that Red Hat’s claims under the Lanham Act and related statelaws are barred by the First Amendment to the U.S. Constitution and the commonlaw privilege of judicial immunity. Red Hat has filed an opposition to ourmotion to dismiss, but the court has not ruled on the motion. We intend tovigorously defend this action.

 

*Novell,Inc.*

 

OnJanuary 20, 2004, we filed suit against Novell, Inc. for slander of titleseeking relief for its alleged bad faith effort to interfere with ourcopyrights related to our UNIX source code and derivative works and ourUnixWare products.  The case is currentlypending in the Third Judicial District Court, Salt Lake County, State of Utah,under the caption *The SCO Group, Inc. v.Novell, Inc.*, Case No. 040900936.  Novell has not yet responded to our complaint  but has filed with the United States District Court for theDistrict of Utah a notice removing the case to such federal court and a motionwith the Third Judicial District Court in Salt Lake County, Utah to transferthe venue of the case from such court to the Fourth Judicial District Court inUtah County, Utah. Neither court has ruled on these actions. Novell also fileda motion to dismiss our complaint claiming it never transferred the copyrightsto The Santa Cruz Operation. We have filed a response to Novell’s motion todismiss and have also filed a motion to remand the case back to the statecourt.  The court has not ruled on thesemotions.  We plan to vigorously pursueits claims against Novell.

 

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Amongour allegations in the suit against Novell, we allege that Novell hasimproperly filed copyright registrations in the United States Copyright Officefor UNIX technology covered by our copyrights and has made false and misleadingpublic claims that it, and not our company, owns the UNIX and UnixWarecopyrights.  We also allege that Novellhas made false statements with the intent to cause customers and potentialcustomers to not do business with us and has attempted, in bad faith, to blockour ability to enforce our copyrights. Additionally, we allege that Novell’sfalse and misleading representations that it owns the UNIX and UnixWarecopyrights have caused us irreparable harm to our copyrights, our business, andour reputation.

 

Inthe lawsuit, we request preliminary and permanent injunctive relief as well asdamages. The injunction would require Novell to assign to us all copyrightsthat we believe Novell has wrongfully registered, prevent Novell fromrepresenting any ownership interest in those copyrights, and require Novell toretract or withdraw all representations it has made regarding its purportedownership of those copyrights.

 

*AutoZone, Inc.*

 

On or about March 2, 2004, we brought suit against AutoZone, Inc.for its alleged violations of our UNIX copyrights through its use ofLinux.  Specifically, the lawsuitalleges that AutoZone violated our UNIX copyrights by running versions of theLinux operating system that contain code, structure, sequence and/ororganization from our proprietary UNIX System V code in violation of ourcopyrights.  The lawsuit filed in U.S.District Court in Nevada requests injunctive relief against AutoZone’s furtheruse or copying of any part of our copyrighted materials and also requestsdamages as a result of AutoZone’s infringement in an amount to be proven attrial.

 

*DaimlerChryslerCorporation*

 

On or about March 3, 2004, we brought suit against DaimlerChryslerCorporation for its alleged violations of its UNIX software agreement withus.  Specifically, the lawsuit allegesthat DaimlerChrysler breached its UNIX software agreement with us by failing tocertify its compliance with the UNIX software agreement as required by us byJanuary 31, 2004.  The lawsuit,filed in Oakland County Circuit Court in the State of Michigan, requests thecourt to issue orders declaring that DaimlerChrysler has violated thecertification requirements of its UNIX software agreement, permanently enjoinDaimlerChrysler from further violations of the UNIX software agreement, issue amandatory injunction requiring DaimlerChrysler to remedy the effects of itspast violations of the UNIX software agreement and award us damages in amountto be determined at trial together with costs, attorneys’ fees and any suchother or different relief that the Court may deem to be equitable and just.

 

*IPOClass Action Matter*

 

We are anissuer defendant in a series of class action lawsuits, involving over 300issuers that have been consolidated under *Inre Initial Public Offering Securities Litigation*, 21 MC 92(SAS).  The plaintiffs, the issuers andthe insurance companies have negotiated a Memorandum of Understanding (“MOU”)with the intent of settling the dispute between the plaintiffs and theissuers.  We have executed this MOU andhave been advised that almost all (if not all) of the issuers have elected toproceed under the MOU.  The MOU is stillsubject to court approval and the preparation of appropriate settlementdocuments.  If the settlement isapproved by the court and settlement agreements can be entered into by theparties, and if no cross-claims, counterclaims or third party claims are laterasserted, this action will be dismissed with respect to us and its individuals.

 

We havenotified our underwriters and insurance companies of the existence of theclaims.  We believe, after consultationwith legal counsel, that the ultimate outcome of this matter

 

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will not havea material adverse effect on our results of operations or financialposition.  As of January 31, 2004,we have paid or accrued the full retention amount of $200,000 under its insurance coverage.

 

*Other Matters*

 

InApril 2003, a former Indian distributor of ours filed a claim in India,requesting summary judgment for payment of $1,428,000, and an order that wetrade in India only through the distributor until the claim is paid. Thedistributor claims that we are responsible to repurchase certain softwareproducts and to reimburse the distributor for certain other operatingcosts.  We do not believe that we areresponsible to reimburse the distributor for any operating costs and alsobelieve that the return rights related to any remaining inventory havelapsed.  We have engaged local counselwho has advised that it is likely that the current claims will fail, but thatthe distributor will continue to pursue its claims either in the Indian courtsor in the U.S. courts.  Discovery hascommenced and initial hearings have been held. We intend to vigorously defend this action.

 

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

 

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**ITEM 6.                  EXHIBITS AND REPORTS ON FORM8-K**

 

(a)                                  Exhibits

 
| 3.1    |   | Amended and Restated Certificate of Incorporation of Caldera  International, Inc. (incorporated by reference to Exhibit 3.1 to SCO’s  Registration Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                                                |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.2    |   | Certificate of Amendment to Amended and Restated Certificate of  Incorporation regarding consolidation of outstanding shares (incorporated by  reference to Exhibit 3.2 to SCO’s Registration Statement on Form 8-A12G/A  (File No. 000-29911)).                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.3    |   | Certificate of Amendment to Amended and Restated Certificate of  Incorporation regarding change of name to The SCO Group, Inc. (incorporated  by reference to Exhibit 3.3 to SCO’s Registration Statement on Form  8A12G/A(File No. 000–29911).                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.4    |   | Amended and Restated Bylaws (incorporated by reference to Exhibit 3.4  to SCO’s Registration Statement on Form 8-A12G/A (File No. 000–29911)).                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.5    |   | Certificate of Designation for Series A Convertible Preferred Stock  (incorporated by reference to Exhibit 3.1 to SCO’s Current Report on Form 8-K  filed on October 17, 2003 (File No. 000-29911)).                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.6    |   | Certificate of Designation for Series A-1 Convertible Preferred Stock  (incorporated by reference to Exhibit 4.1 to SCO’s Current Report on Form 8-K  filed on February 9, 2004 (File No. 000-29911)).                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.7    |   | Certificate  of Correction correcting the Certificate of Designation for Series A-1  Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to  SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No.  000-29911)).                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.1   |   | Letter  Amending Engagement Agreement dated November 17, 2003 from Darl C.  McBride, President and Chief Executive Officer of SCO, to David Boies of  Boies, Schiller & Flexner LLP (incorporated by reference to Exhibit 99.2  to SCO’s Current Report on Form 8-K filed on December 9, 2003 (File No.  000-29911)). |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.2   |   | Letter  Agreement dated December 8, 2003 among SCO, BayStar Capital II, L.P., Royal  Bank of Canada and Boies, Schiller & Flexner LLP (incorporated by  reference to Exhibit 99.3 to SCO’s Current Report on Form 8-K filed on  December 9, 2003 (File No. 000-29911)).                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 31.1   |   | Certification of Darl C. McBride, President and Chief Executive  Officer, pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 31.2   |   | Certification of Robert K. Bench, Chief Financial Officer, pursuant  to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                     |
| 32.1   |   | Certification of Darl C. McBride, President and Chief Executive  Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States  Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                                        |

 

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| 32.2 |   | Certification of Robert K. Bench, 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. |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

(b)                                 Reports on Form 8-K

 
| On November 5, 2003, we filed a Current Report on Form 8-K  announcing the appointment of Daniel W. Campbell to our Board of Directors.                                                                                  |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                          |
| On November 18, 2003, we filed a Current Report on Form 8-K  announcing we had expanded our agreement with the law firms representing us  in our intellectual property claims.                                           |
|                                                                                                                                                                                                                          |
| On November 19, 2003, we filed a Current Report on Form 8-K  announcing we had filed certain agreements related to the Asset Purchase  between The Santa Cruz Operation, Inc. and Novell, Inc.                           |
|                                                                                                                                                                                                                          |
| On December 9, 2003, we filed a Current Report on Form 8-K  announcing we had entered into a letter agreement with the two investors in  our Series A Convertible Preferred Stock financing.                             |
|                                                                                                                                                                                                                          |
| On December 22, 2003, we filed a Current Report on Form 8-K  announcing our fourth quarter and fiscal year 2003 operating results.                                                                                       |
|                                                                                                                                                                                                                          |
| On January 13, 2004, we   filed a Current Report on Form 8-K announcing a Notice of Compliance  with a Court Order, filed with the United States District Court for the  District of Utah on January 12, 2004. |
|                                                                                                                                                                                                                          |
| On January 21, 2004, we   filed a Current Report on Form 8-K announcing we had filed suit  against Novell, Inc. for its alleged bad faith effort to interfere with our  rights with respect to UNIX and UnixWare.   |

 

**ITEM 7.                  SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
| Date:  March 16, 2004 | THE SCO GROUP, INC. |
|---------------------------------|---------------------|
|                            |                |
|                            |                | By: | /s/ Robert K. Bench |   |
|                            |                | Robert K. Bench |
|                            |                | Duly Authorized Officer and |
|                            |                | Chief Financial Officer |
|                            |                | (Principal Financial and |
|                            |                | Accounting Officer) |

** **

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**EXHIBITINDEX**

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| **Exhibit  Number** |   | **Exhibit  Description**                                                                                                                                                                                                                                                                                                                 |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.1                 |   | Amended and Restated Certificate of Incorporation of Caldera  International, Inc. (incorporated by reference to Exhibit 3.1 to SCO’s  Registration Statement on Form 8-A12G/A (File No. 000-29911)).                                                                                                                                |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.2                 |   | Certificate of Amendment to Amended and Restated Certificate of  Incorporation regarding consolidation of outstanding shares (incorporated by  reference to Exhibit 3.2 to SCO’s Registration Statement on Form 8-A12G/A  (File No. 000-29911)).                                                                                    |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.3                 |   | Certificate of Amendment to Amended and Restated Certificate of  Incorporation regarding change of name to The SCO Group, Inc. (incorporated  by reference to Exhibit 3.3 to SCO’s Registration Statement on Form  8A12G/A(File No. 000–29911).                                                                                |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.4                 |   | Amended and Restated Bylaws (incorporated by reference to Exhibit 3.4  to SCO’s Registration Statement on Form 8-A12G/A (File No. 000–29911)).                                                                                                                                                                                 |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.5                 |   | Certificate of Designation for Series A Convertible Preferred Stock  (incorporated by reference to Exhibit 3.1 to SCO’s Current Report on Form 8-K  filed on October 17, 2003 (File No. 000-29911)).                                                                                                                           |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.6                 |   | Certificate of Designation for Series A-1 Convertible Preferred Stock  (incorporated by reference to Exhibit 4.1 to SCO’s Current Report on Form 8-K  filed on February 9, 2004 (File No. 000-29911)).                                                                                                                         |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.7                 |   | Certificate  of Correction correcting the Certificate of Designation for Series A-1  Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to  SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No.  000-29911)).                                                                              |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.1                |   | Letter  Amending Engagement Agreement dated November 17, 2003 from Darl C.  McBride, President and Chief Executive Officer of SCO, to David Boies of  Boies, Schiller & Flexner LLP (incorporated by reference to Exhibit 99.2  to SCO’s Current Report on Form 8-K filed on December 9, 2003 (File No.  000-29911)). |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 10.2                |   | Letter  Agreement dated December 8, 2003 among SCO, BayStar Capital II, L.P.,  Royal Bank of Canada and Boies, Schiller & Flexner LLP (incorporated by  reference to Exhibit 99.3 to SCO’s Current Report on Form 8-K filed on  December 9, 2003 (File No. 000-29911)).                                               |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 31.1                |   | Certification of Darl C. McBride, President and Chief Executive  Officer, pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                    |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 31.2                |   | Certification of Robert K. Bench, Chief Financial Officer, pursuant  to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 32.1                |   | Certification of Darl C. McBride, President and Chief Executive  Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States  Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                                        |

 

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| **32.2** |   | **Certification of Robert K. Bench, 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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