** **

**UNITED STATES**

** **

**SECURITIES AND EXCHANGECOMMISSION**

** **

**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 JULY 31, 2003**                                                                                                                                                                                                                                                           |
|                                                                                                                                                                                                                                                                                                             |
| **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 asspecified in its charter)

 

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

 

Indicate by check mark whether theRegistrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to filing requirements for the past 90 days.

 

YES ý NO o

 

Indicate by check mark whether theregistrant is an accelerated filer (as defined in Rule 12b-2 of the ExchangeAct)

 

YES o NO ý

 

*As of September 11, 2003, there were 13,845,797 sharesof the Registrant’s common stock outstanding.*

 

 

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**The SCO Group, Inc.**

 

**Tableof Contents**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                                                |
|----------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.  | Financial  Statements                                                                                                                                |
|     | Condensed  Consolidated Balance Sheets as of July 31, 2003 and   October 31, 2002                                                          |
|     | Condensed  Consolidated Statements of Operations and   Comprehensive Income (Loss) for the three and nine months ended   July 31, 2003 and 2002 |
|     | Condensed  Consolidated Statements of Cash Flows for the nine   months ended July 31, 2003 and 2002                                             |
|     | Notes  to Condensed Consolidated Financial Statements                                                                                                |
| Item 2.  | Management’s Discussion and  Analysis of Financial Condition and   Results of Operations                                                        |
| Item 3.  | Quantitative and Qualitative  Disclosures About Market Risk                                                                                          |
| Item 4.  | Controls and Procedures                                                                                                                              |
|     | Forward-Looking Statements                                                                                                                           |
|     | Risk Factors                                                                                                                                         |
| PART II. | OTHER INFORMATION                                                                                                                                    |
| Item  1. | Legal  Proceedings                                                                                                                                   |
| Item  2. | Changes  in Securities and Use of Proceeds                                                                                                           |
| Item  4. | Submission  of Matters to a Vote of Security Holders                                                                                                 |
| Item 6.  | Exhibits and  Reports on Form 8-K                                                                                                                    |
| Item 7.  | Signatures                                                                                                                                           |

 

2

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

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(unaudited, in thousands)**

 
|                                                                                                           |   | **July 31,  2003** |       | **October 31,  2002** |       |
|----------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                     |   |                    | ** ** |                       | ** ** |
|                                                                                                           |   |                    |       |                       |       |
| CURRENT  ASSETS:                                                                                               |   |                    |       |                       |       |
| Cash  and cash equivalents                                                                                     |   | $                       | 14,661     |                       | $          | 6,589 |   |
| Restricted  cash                                                                                               |   | 1,428                   |       | 1,428                      |       |
| Accounts  receivable, net of allowance for doubtful accounts of $138 and $348,  respectively                   |   | 7,398                   |       | 8,622                      |       |
| Other                                                                                                          |   | 2,943                   |       | 4,483                      |       |
| Total  current assets                                                                                          |   | 26,430                  |       | 21,122                     |       |
|                                                                                                           |   |                    |       |                       |       |
| PROPERTY  AND EQUIPMENT:                                                                                       |   |                    |       |                       |       |
| Computer  and office equipment                                                                                 |   | 3,178                   |       | 3,884                      |       |
| Leasehold  improvements                                                                                        |   | 627                     |       | 724                        |       |
| Furniture  and fixtures                                                                                        |   | 196                     |       | 201                        |       |
|                                                                                                           |   | 4,001                   |       | 4,809                      |       |
| Less  accumulated depreciation and amortization                                                                |   | (2,440                  | )          | (2,788                     | )          |
| Net  property and equipment                                                                                    |   | 1,561                   |       | 2,021                      |       |
|                                                                                                           |   |                    |       |                       |       |
| OTHER  ASSETS:                                                                                                 |   |                    |       |                       |       |
| Goodwill                                                                                                       |   | 1,166                   |       | —                     |       |
| Intangibles,  net                                                                                              |   | 10,265                  |       | 11,258                     |       |
| Other                                                                                                          |   | 3,210                   |       | 3,005                      |       |
| Total  other assets                                                                                            |   | 14,641                  |       | 14,263                     |       |
|                                                                                                           |   |                    |       |                       |       |
| Total  assets                                                                                                  |   | $                       | 42,632     |                       | $          | 37,406 |   |
|                                                                                                           |   |                    |       |                       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                 |   |                    | ** ** |                       | ** ** |
|                                                                                                           |   |                    |       |                       |       |
| CURRENT  LIABILITIES:                                                                                          |   |                    |       |                       |       |
| Accounts  payable                                                                                              |   | $                       | 1,788      |                       | $          | 2,467 |   |
| Taxes  payable                                                                                                 |   | 846                     |       | 1,113                      |       |
| Royalty  payable to Novell, Inc.                                                                               |   | 1,428                   |       | 1,428                      |       |
| Other  royalties payable                                                                                       |   | 668                     |       | 669                        |       |
| Accrued  payroll and benefits                                                                                  |   | 3,312                   |       | 4,089                      |       |
| Other  current liabilities                                                                                     |   | 5,559                   |       | 7,632                      |       |
| Deferred  revenue                                                                                              |   | 6,822                   |       | 10,056                     |       |
| Total  current liabilities                                                                                     |   | 20,423                  |       | 27,454                     |       |
|                                                                                                           |   |                    |       |                       |       |
| LONG-TERM  LIABILITIES                                                                                         |   | 611                     |       | 1,625                      |       |
|                                                                                                           |   |                    |       |                       |       |
| COMMITMENTS  AND CONTINGENCIES (Note 8)                                                                        |   |                    |       |                       |       |
|                                                                                                           |   |                    |       |                       |       |
| MINORITY  INTEREST                                                                                             |   | 150                     |       | 150                        |       |
|                                                                                                           |   |                    |       |                       |       |
| STOCKHOLDERS’  EQUITY:                                                                                    |   |                    |       |                       |       |
| Preferred  stock, $0.001 par value; 5,000 shares authorized, none outstanding                                  |   | —                  |       | —                     |       |
| Common  stock, $0.001 par value; 45,000 shares authorized, 13,663 and 11,412 shares  outstanding, respectively |   | 14                      |       | 11                         |       |
| Additional  paid-in capital                                                                                    |   | 219,753                 |       | 214,299                    |       |
| Warrants  outstanding                                                                                          |   | 744                     |       | 294                        |       |
| Deferred  compensation                                                                                         |   | (582                    | )          | (644                       | )          |
| Accumulated  other comprehensive income                                                                        |   | 940                     |       | 510                        |       |
| Accumulated  deficit                                                                                           |   | (199,421                | )          | (206,293                   | )          |
| Total  stockholders’ equity                                                                               |   | 21,448                  |       | 8,177                      |       |
|                                                                                                           |   |                    |       |                       |       |
| Total  liabilities and stockholders’ equity                                                               |   | $                       | 42,632     |                       | $          | 37,406 |   |

 

See notes tocondensed consolidated financial statements.

 

3

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

 

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**AND COMPREHENSIVE INCOME (LOSS)**

**(unaudited)**

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

 
|                                                                                                                      |   | **Three  Months Ended July 31,** |   | **Nine  Months Ended July 31,** |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                                                                                      |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
| REVENUE:                                                                                                                  |   |                                  |   |                                 |   |   |   |   |   |
| Products                                                                                                                  |   | $                                     | 10,804 |                                 | $      | 12,639 |   | $ | 33,016 |   | $ | 40,151 |   |
| SCOsource  licensing                                                                                                      |   | 7,280                                 |   | —                               |   | 15,530 |   | — |   |
| Services                                                                                                                  |   | 1,971                                 |   | 2,745                                |   | 6,418 |   | 8,622 |   |
| Total  revenue                                                                                                            |   | 20,055                                |   | 15,384                               |   | 54,964 |   | 48,773 |   |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| COST  OF REVENUE:                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Products                                                                                                                  |   | 1,284                                 |   | 1,577                                |   | 3,676 |   | 6,398 |   |
| SCOsource  licensing                                                                                                      |   | 1,712                                 |   | —                               |   | 3,875 |   | — |   |
| Services                                                                                                                  |   | 1,538                                 |   | 2,494                                |   | 5,008 |   | 8,809 |   |
| Total  cost of revenue                                                                                                    |   | 4,534                                 |   | 4,071                                |   | 12,559 |   | 15,207 |   |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| GROSS  MARGIN                                                                                                             |   | 15,521                                |   | 11,313                               |   | 42,405 |   | 33,566 |   |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| OPERATING  EXPENSES:                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| Sales  and marketing (exclusive of stock-based compensation (benefit) of $31, ($94),  $98 and $19, respectively)          |   | 5,930                                 |   | 6,908                                |   | 18,421 |   | 22,944 |   |
| Research  and development (exclusive of stock-based compensation (benefit) of $29,  ($156), $82 and ($22), respectively)  |   | 2,950                                 |   | 4,284                                |   | 8,142 |   | 13,810 |   |
| General  and administrative (exclusive of stock-based compensation (benefit) of $249,  $161, $747 and $531, respectively) |   | 1,413                                 |   | 2,260                                |   | 4,525 |   | 7,394 |   |
| Write-down  of investment                                                                                                 |   | —                                |   | —                               |   | — |   | 1,180 |   |
| Restructuring  charges                                                                                                    |   | 614                                   |   | 1,245                                |   | 498 |   | 5,581 |   |
| Amortization  of intangibles                                                                                              |   | 895                                   |   | 701                                  |   | 2,295 |   | 2,152 |   |
| Loss  on disposition and write-down of long-lived assets                                                                  |   | —                                |   | 246                                  |   | — |   | 1,574 |   |
| Stock-based  compensation (benefit)                                                                                       |   | 309                                   |   | (89                                  | )      | 927 |   | 528 |   |
| Total  operating expenses                                                                                                 |   | 12,111                                |   | 15,555                               |   | 34,808 |   | 55,163 |   |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| INCOME  (LOSS) FROM OPERATIONS                                                                                            |   | 3,410                                 |   | (4,242                               | )      | 7,597 |   | (21,597 | ) |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| EQUITY  IN LOSS OF AFFILIATE                                                                                              |   | (71                                   | )      | —                               |   | (171 | ) | — |   |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| OTHER  INCOME (EXPENSE):                                                                                                  |   |                                  |   |                                 |   |   |   |   |   |
| Interest  income                                                                                                          |   | 42                                    |   | 83                                   |   | 92 |   | 336 |   |
| Interest  expense                                                                                                         |   | (3                                    | )      | —                               |   | (3 | ) | (208 | ) |
| Other  expense, net                                                                                                       |   | (94                                   | )      | (138                                 | )      | (148 | ) | (248 | ) |
| Total  other expense, net                                                                                                 |   | (55                                   | )      | (55                                  | )      | (59 | ) | (120 | ) |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| INCOME  (LOSS) BEFORE INCOME TAXES                                                                                        |   | 3,284                                 |   | (4,297                               | )      | 7,367 |   | (21,717 | ) |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| PROVISION  FOR INCOME TAXES                                                                                               |   | (188                                  | )      | (214                                 | )      | (495 | ) | (431 | ) |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| NET  INCOME (LOSS)                                                                                                        |   | $                                     | 3,096  |                                 | $      | (4,511 | ) | $ | 6,872 |   | $ | (22,148 | ) |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| BASIC  NET INCOME (LOSS) PER COMMON SHARE                                                                                 |   | $                                     | 0.25   |                                 | $      | (0.35 | ) | $ | 0.58 |   | $ | (1.58 | ) |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| DILUTED  NET INCOME (LOSS) PER COMMON SHARE                                                                               |   | $                                     | 0.19   |                                 | $      | (0.35 | ) | $ | 0.47 |   | $ | (1.58 | ) |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| WEIGHTED  AVERAGE BASIC COMMON SHARES OUTSTANDING                                                                         |   | 12,469                                |   | 12,714                               |   | 11,753 |   | 14,031 |   |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| WEIGHTED  AVERAGE DILUTED COMMON SHARES OUTSTANDING                                                                       |   | 16,180                                |   | 12,714                               |   | 14,744 |   | 14,031 |   |
|                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
| OTHER  COMPREHENSIVE INCOME (LOSS):                                                                                       |   |                                  |   |                                 |   |   |   |   |   |
| Net  income (loss)                                                                                                        |   | $                                     | 3,096  |                                 | $      | (4,511 | ) | $ | 6,872 |   | $ | (22,148 | ) |
| Foreign  currency translation adjustments                                                                                 |   | 204                                   |   | 416                                  |   | 430 |   | 181 |   |
| COMPREHENSIVE  INCOME (LOSS)                                                                                              |   | $                                     | 3,300  |                                 | $      | (4,095 | ) | $ | 7,302 |   | $ | (21,967 | ) |

 

See notes tocondensed consolidated financial statements.

 

4

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

 

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(unaudited, in thousands)**

 
|                                                                                                             |   | **Nine  Months Ended July 31,** |   |
|------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                                                             |   | **2003**                             |   | **2002** |   |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                                           |   |                                 |   |   |   |
| Net  income (loss)                                                                                               |   | $                                    | 6,872  |   | $ | (22,148 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities:             |   |                                 |   |   |   |
| Amortization  of goodwill and intangibles (including $253 and $252 classified as cost of  revenue, respectively) |   | 2,548                                |   | 2,404 |   |
| Stock-based  compensation                                                                                        |   | 927                                  |   | 528 |   |
| Depreciation  and amortization                                                                                   |   | 815                                  |   | 2,042 |   |
| Equity  in loss of affiliate                                                                                     |   | 171                                  |   | — |   |
| Issuance  of a warrant included as cost of SCOsource licensing revenue                                           |   | 94                                   |   | — |   |
| Loss  on disposition and write-down of long-lived assets                                                         |   | —                               |   | 1,574 |   |
| Write-down  of investment                                                                                        |   | —                               |   | 1,180 |   |
| Amortization  of debt discount                                                                                   |   | —                               |   | 250 |   |
| Changes  in operating assets and liabilities, net of effect of disposition of SCO Group,  Ltd.                   |   |                                 |   |   |   |
| Accounts  receivable, net                                                                                        |   | 1,047                                |   | 5,788 |   |
| Other  current assets                                                                                            |   | 854                                  |   | (342 | ) |
| Other  assets                                                                                                    |   | 1,140                                |   | 497 |   |
| Accounts  payable                                                                                                |   | (407                                 | )      | (1,205 | ) |
| Payable  to Tarantella, Inc.                                                                                     |   | —                               |   | (15 | ) |
| Accrued  payroll and benefits                                                                                    |   | (325                                 | )      | (2,429 | ) |
| Other  current liabilities                                                                                       |   | (2,286                               | )      | (12 | ) |
| Deferred  revenue                                                                                                |   | (3,234                               | )      | 3,037 |   |
| Taxes  payable                                                                                                   |   | 137                                  |   | (172 | ) |
| Other  royalties payable                                                                                         |   | (1                                   | )      | (886 | ) |
| Other  long-term liabilities                                                                                     |   | (910                                 | )      | 175 |   |
| Net  cash provided by (used in) operating activities                                                             |   | 7,442                                |   | (9,734 | ) |
|                                                                                                             |   |                                 |   |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                                           |   |                                 |   |   |   |
| Purchase  of property and equipment                                                                              |   | (524                                 | )      | (94 | ) |
| Acquisitions,  net of acquisition costs and cash received                                                        |   | —                               |   | (100 | ) |
| Proceeds  from available-for-sale securities                                                                     |   | —                               |   | 5,943 |   |
| Cash  paid to wind up SCO Group, Ltd.                                                                            |   | (666                                 | )      | — |   |
| Investments  in and loans to affiliated entities                                                                 |   | (950                                 | )      | — |   |
| Net  cash provided by (used in) investing activities                                                             |   | (2,140                               | )      | 5,749 |   |
|                                                                                                             |   |                                 |   |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                                           |   |                                 |   |   |   |
| Repayments  of long-term debt                                                                                    |   | —                               |   | (5,000 | ) |
| Purchase  of common shares from existing stockholders                                                            |   | —                               |   | (4,584 | ) |
| Proceeds  from sale of common stock through ESP program                                                          |   | 236                                  |   | 291 |   |
| Issuance  of warrants                                                                                            |   | 650                                  |   | — |   |
| Proceeds  from exercise of common stock options                                                                  |   | 1,443                                |   | 112 |   |
| Net  cash provided by (used in) financing activities                                                             |   | 2,329                                |   | (9,181 | ) |
|                                                                                                             |   |                                 |   |   |   |
| NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                            |   | 7,631                                |   | (13,166 | ) |
| EFFECT  OF FOREIGN EXCHANGE RATES ON CASH                                                                        |   | 441                                  |   | 340 |   |
| CASH  AND CASH EQUIVALENTS, beginning of period                                                                  |   | 6,589                                |   | 22,435 |   |
| CASH  AND CASH EQUIVALENTS, end of period                                                                        |   | $                                    | 14,661 |   | $ | 9,609 |   |
|                                                                                                             |   |                                 |   |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                                               |   |                                 |   |   |   |
|                                                                                                             |   |                                 |   |   |   |
| Cash  paid for taxes                                                                                             |   | $                                    | 297    |   | $ | 748 |   |
|                                                                                                             |   |                                 |   |   |   |
| SUPPLEMENTAL  SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:                                       |   |                                 |   |   |   |
|                                                                                                             |   |                                 |   |   |   |
| Settlement  related to Tarantella acquisition reflected as an adjustment to the purchase  price                  |   | $                                    | — |   | $ | 3,341 |   |
|                                                                                                             |   |                                 |   |   |   |
| Acquisition  of Vultus, Inc.:                                                                                    |   |                                 |   |   |   |
| Common  stock issued                                                                                             |   | $                                    | 2,461  |   | $ | — |   |
| Accrued  liabilities assumed                                                                                     |   | $                                    | 215    |   | $ | — |   |

 

See notes tocondensed consolidated financial statements.

 

5

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

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

## ** **

The Company wasoriginally incorporated as Caldera Systems, Inc. (“Caldera Systems”), a Utahcorporation, on August 21, 1998, and reincorporated as a Delawarecorporation on March 6, 2000.  InMarch 2000, Caldera Systems completed an initial public offering of itscommon stock.

 

On May 7, 2001, Caldera International, Inc.(“Caldera”) was formed as a holding company to own Caldera Systems and toacquire substantially all of the assets, liabilities and operations of theserver and professional services groups of Tarantella, Inc. (“Tarantella”),formerly The Santa Cruz Operation, Inc., pursuant to an Agreement and Plan ofReorganization (the “Reorganization Agreement”), dated as of August 1,2000, as amended.  Under theReorganization Agreement, Caldera acquired the tangible and intangible assetsused in the server and professional services groups, including all of thecapital stock of certain Tarantella subsidiaries.  In connection with the formation of Caldera, Caldera Systemsbecame a 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 from Tarantella developed andmarketed server software related to networked business computing and were oneof the leading providers of UNIX server operating systems.  In addition, these operations providedprofessional services related to implementing and maintaining UNIX systemsoftware products.  The acquisitionprovided Caldera with international offices and a distribution channel withresellers throughout the world. Subsequent to this acquisition, the Company has primarily sold UNIXbased products and services.

 

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

 

TheCompany’s business continues to focus on marketing reliable, cost-effectiveUNIX software products and related services and developing web services for thesmall to medium business market.  TheCompany is also pursuing its SCOx strategy to provide a common framework forthe integration of internet applications (web services) and server basedapplications.  In addition, the Companyestablished its SCOsource division in January 2003 to review and enforceits intellectual property surrounding the UNIX operating system which itacquired from Tarantella.

 

TheCompany will continue to market and sell its UNIX-based products and relatedservices to customers through an indirect, leveraged worldwide channel ofpartners, which includes distributors and solution providers.  This worldwide distribution channel locallysupports customers and resellers with minor modifications that fit theirparticular country’s needs.

 

6

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

 

### **Basisof Presentation**

 

The accompanying unaudited condensed consolidatedfinancial statements of the Company have been prepared by the Company pursuantto the rules and regulations of the Securities and Exchange Commission (“SEC”)on a basis consistent with the Company’s audited annual financial statements,and, in the opinion of management, reflect all adjustments, consisting ofnormal recurring adjustments, necessary to present fairly the financialinformation set forth therein.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted pursuant to SEC rulesand regulations, although the Company believes that the following disclosures,when read in conjunction with the audited annual financial statements and thenotes thereto included in the Company’s most recent annual report on Form 10-K,are adequate to make the information presented not misleading.

 

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

### ** **

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period.  Actual results could differ from these estimates.  The Company’s critical accounting policiesand estimates, as discussed in the Company’s most recent annual report on Form10-K and related amendments, include, among others, revenue recognition, incometaxes and related valuation allowances, impairment of long-lived assets andallowances for doubtful accounts and product returns.

 

### **RevenueRecognition**

### ** **

The Company’s revenue is from three sources: (i)product license revenue, primarily from product sales to resellers and endusers, and royalty revenue from product sales by source code OEMs; (ii) serviceand support revenue, primarily from providing software updates, support andeducation and consulting services to end users; and (iii) licensing revenuefrom its intellectual property initiative, SCOsource.

 

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.

 

For contracts involving multiple elements (i.e.,delivered and undelivered products, maintenance and other services), theCompany allocates revenue to each component of the contract based on objectiveevidence of its fair value, which is specific to the Company.  The fair value of each element is based onamounts charged when such elements are sold separately.  The Company recognizes revenue allocated toundelivered products when the criteria for product revenue set forth above havebeen met.

 

The Company’s SCOsource licensing revenue to date hasbeen generated from license agreements that are non-exclusive, perpetual, paidup licenses to utilize the Company’s UNIX source code.  The Company recognizes revenue from licensingagreements when a signed contract exists, the fee is fixed and 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 becomedue.

 

7

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The Company recognizes revenue from maintenance feesfor ongoing customer support and product updates ratably over the period of themaintenance contract.  Payments formaintenance fees are generally made in advance and are non-refundable.  For revenue allocated to education andconsulting services or derived from the separate sale of such services, theCompany recognizes revenue as the related services are performed.

 

The Company recognizes product revenue from royaltypayments upon receipt of royalty reports from OEMs related to their productsales.

 

**Hedging of Foreign Currency Transactions**

 

In June 1998, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.133, “Accounting for Derivative Instruments and Certain HedgingActivities.”  In June 2000, theFASB issued SFAS No. 138, “Accounting for Certain Derivative Instruments andCertain Hedging Activity, an Amendment of SFAS 133.”  SFAS No. 133 and SFAS No. 138 require that all derivativeinstruments be recorded on the balance sheet at their respective fair values.

 

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 exchangecontracts to underlying transactions. Gains and losses on currency forward contracts that are designated andeffective as hedges of firm commitments are deferred and recognized in incomein the same period that the underlying transactions are settled.  Gains and losses on currency forward contractsthat are designated and effective as hedges of existing transactions arerecognized in income in the same period as losses and gains on the underlyingtransactions are recognized and generally offset.  Gains and losses on any instruments not meeting the abovecriteria are recognized in income in the current period.  As of July 31, 2003, the Company hadtwo foreign exchange contracts with a maturity of 30 days to sell an aggregateof 243,000 Euro and 689,000 United Kingdom pounds for $1,334,000 U.S. dollars.

 

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

 

Basic net income (loss) per common share (“Basic EPS”)is computed by dividing net income (loss) by the weighted average number ofcommon shares outstanding.  Diluted netincome (loss) per common share (“Diluted EPS”) is computed by dividing netincome (loss) by the sum of the weighted average number of common sharesoutstanding and the dilutive potential common share equivalents thenoutstanding.  Potential common shareequivalents consist of the weighted average of shares issuable upon theexercise of outstanding stock options, restricted stock awards and warrants toacquire common stock.  The followingtable is a reconciliation of the numerator and denominator of Basic EPS to thenumerator and denominator of Diluted EPS (in thousands, except per share amounts):

 
|                                             |   | **Three  Months Ended July 31,** |   | **Nine  Months Ended July 31,** |   |
|--------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                             |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                             |   |                                  |   |                                 |   |   |   |   |   |
| Numerator:                                       |   |                                  |   |                                 |   |   |   |   |   |
| Net  income (loss)                               |   | $                                     | 3,096  |                                 | $      | (4,511 | ) | $ | 6,872 |   | $ | (22,148 | ) |
|                                             |   |                                  |   |                                 |   |   |   |   |   |
| Denominator:                                     |   |                                  |   |                                 |   |   |   |   |   |
| Weighted  average common shares outstanding      |   | 12,469                                |   | 12,714                               |   | 11,753 |   | 14,031 |   |
| Effect  of stock options                         |   | 3,032                                 |   | —                               |   | 2,485 |   | — |   |
| Effect  of restricted stock awards               |   | 515                                   |   | —                               |   | 433 |   | — |   |
| Effect  of warrants                              |   | 164                                   |   | —                               |   | 73 |   | — |   |
| Total                                            |   | 16,180                                |   | 12,714                               |   | 14,744 |   | 14,031 |   |
|                                             |   |                                  |   |                                 |   |   |   |   |   |
| Basic  EPS                                       |   | $                                     | 0.25   |                                 | $      | (0.35 | ) | $ | 0.58 |   | $ | (1.58 | ) |
| Diluted  EPS                                     |   | 0.19                                  |   | (0.35                                | )      | 0.47 |   | (1.58 | ) |
|                                             |   |                                  |   |                                 |   |   |   |   |   |
| Excluded  anti-dilutive common share equivalents |   | 212                                   |   | 3,341                                |   | 360 |   | 2,672 |   |

 

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**Pro Forma Fair Value of Stock-basedCompensation**

 

SFAS No. 148, “Accounting for Stock-BasedCompensation,” requires pro forma information regarding net income(loss) as if the Company had accounted for its stock options granted under thefair value method.  The fair value forthe Company’s stock options is estimated on the date of grant using theBlack-Scholes option-pricing model.

 

Withrespect to stock options and restricted stock awards granted during the threeand nine months ended July 31, 2003, the assumptions used to estimate fairvalue were as follows: risk-free interest rate of 3.4 percent; expecteddividend yield of 0 percent; volatility of 157 percent and 132 percent,respectively; and expected exercise life of 2.6 years.

 

Withrespect to the stock options granted during the three and nine months endedJuly 31, 2002, the assumptions used to estimate fair value were asfollows: risk-free interest rate of 3.5 percent; expected dividend yield of 0percent; volatility of 149 percent and 165 percent, respectively; and expectedexercise life of 2.8 years.

 

Forpurposes of the pro forma disclosure, the estimated fair value of the stockoptions and restricted stock awards are amortized over the vesting period ofthe award.  The following is the proforma disclosure and the related impact on net income (loss) and the net income(loss) per diluted common share for the three and nine months endedJuly 31, 2003 and 2002 (in thousands, except per share amounts):****

 
|                                                             |   | **Three  Months Ended July 31,** |   | **Nine  Months Ended July 31,** |   |
|------------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                             |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                                             |   |                                  |   |                                 |   |   |   |   |   |
| Net  income (loss):                                              |   |                                  |   |                                 |   |   |   |   |   |
| As  reported                                                     |   | $                                     | 3,096  |                                 | $      | (4,511 | ) | $ | 6,872 |   | $ | (22,148 | ) |
| Stock-based  compensation included in reported net income (loss) |   | 309                                   |   | (89                                  | )      | 927 |   | 528 |   |
| Stock-based  compensation under fair value method                |   | (507                                  | )      | (1,329                               | )      | (1,446 | ) | (5,356 | ) |
| Pro  forma net income (loss)                                     |   | $                                     | 2,898  |                                 | $      | (5,929 | ) | $ | 6,353 |   | $ | (26,976 | ) |
|                                                             |   |                                  |   |                                 |   |   |   |   |   |
| Net  income (loss) per diluted common share:                     |   |                                  |   |                                 |   |   |   |   |   |
| As  reported                                                     |   | $                                     | 0.19   |                                 | $      | (0.35 | ) | $ | 0.47 |   | $ | (1.58 | ) |
| Pro  forma                                                       |   | $                                     | 0.18   |                                 | $      | (0.47 | ) | $ | 0.43 |   | $ | (1.92 | ) |

 

**(3) ACQUISITION OF VULTUS, INC.**

 

Under the terms of an AssetAcquisition Agreement (the “Vultus Agreement”) dated June 6, 2003, theCompany acquired substantially all of the assets of Vultus, Inc. (“Vultus”), acorporation engaged in the web services interface business, in exchange for theissuance of 167,590 shares of the Company’s common stock, of which The CanopyGroup (“Canopy”), the

 

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Company’sprincipal stockholder, received 36,656 shares, and the assumption ofapproximately $215,000 in accrued liabilities of Vultus.  In addition, the Company assumed theobligations of Vultus under two secured notes payable to Canopy totaling$1,073,000.  In connection with theassumption of the notes payable to Canopy, Canopy agreed to accept the issuanceof 137,684 shares of the Company’s common stock in full satisfaction of theobligations.  Canopy was a stockholderand significant debt holder of Vultus. The Company extended employment offers to most of the former employeesof Vultus.  Vultus is expected to be anintegral part of the Company’s web services strategy.

 

The following tablesummarizes the components of the consideration paid to Vultus (in thousands,except per share data):

 
| Consideration  paid:                                                   |   |   | * * |
|------------------------------------------------------------------------|--------|--------|----------|
| Fair  value of common stock issued (305,274 shares at $8.06 per share) |   | $      | 2,461    |   |
| Assumed  liabilities                                                   |   | 215    |     |
| Direct  expenses                                                       |   | 45     |     |
| Total  consideration                                                   |   | $      | 2,721    |   |

 

The $8.06 per share value of the common stock issuedwas determined based on the average market price of the Company’s common stockfor the two days before and the day of signing the Vultus Agreement.

 

TheCompany accounted for the acquisition of Vultus as a business combination inaccordance with SFAS No. 141.  SFAS No.141 requires that the total purchase price, including direct fees and expenses,be allocated to the assets acquired based upon their respective fair values.  No current assets or tangible assets ofsignificant value were acquired.  Basedon the nature and status of the research and development projects at the dateof acquisition, none of the purchase price has been allocated to in-processresearch and development.  The purchaseprice has been allocated to the intangible assets acquired as follows (inthousands):

 
| Purchase  price allocation:                               |   |   | * * |
|-----------------------------------------------------------|--------|--------|----------|
| Acquired  technology (Estimated useful life of two years) |   | $      | 1,555    |   |
| Goodwill                                                  |   | 1,166  |     |
| Total                                                     |   | $      | 2,721    |   |

 

All of the amounts assignedto goodwill are expected to be deductible for tax purposes.

 

**(4) INTANGIBLE ASSETS**

 

In July 2001, the FASB issued SFAS No. 142,“Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill and other intangible assets with indefinitelives are no longer amortized, but rather are assessed annually for impairment.  The Company adopted SFAS No. 142 onNovember 1, 2001, the beginning of fiscal year 2002.  All of the Company’s identifiable intangibleassets are deemed to have finite lives and are amortized over their remaininguseful lives.

 

Identifiable intangible assets are the result of theacquisition of certain assets and operations from Tarantella, the acquisitionof the WhatIfLinux technology from Acrylis, Inc, and the acquisition of certainassets from Vultus.

 

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

 

10

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|                                   |   | **Estimated  Useful Life** |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   | **Net Book  Value** |   |
|----------------------------------------|--------|----------------------------|--------|-----------------------------|--------|-------------------------------|--------|---------------------|--------|
| Amortizable  intangible assets:        |   |                       |   |                        |   |                          |   |                |   |
| Distribution/reseller  channel         |   | 5 years                    |   | $                           | 11,626 |                          | $      | 4,093               |   | $ | 7,533 |   |
| Acquired  technology – Tarantella |   | 5 years                    |   | 1,687                       |   | 594                           |   | 1,093               |   |
| Acquired  technology – Acrylis    |   | 2 years                    |   | 871                         |   | 763                           |   | 108                 |   |
| Acquired  technology – Vultus     |   | 2 years                    |   | 1,555                       |   | 193                           |   | 1,362               |   |
| Trade  name and trademarks             |   | 5 years                    |   | 261                         |   | 92                            |   | 169                 |   |
| Total  intangible assets               |   |                       |   | $                           | 16,000 |                          | $      | 5,735               |   | $ | 10,265 |   |

 

The changes in the carrying amount of goodwill are asfollows (in thousands): 

 
| Balance  as of October 31, 2002             |   | $     | — |   |
|--------------------------------------------------|--------|-------|--------|--------|
| Goodwill  attributable to the Vultus acquisition |   | 1,166 |   |
| Balance  as of July 31, 2003                |   | $     | 1,166  |   |

 

**(5) INVESTMENT IN VISTA.COM**

 

During August 2002, theCompany entered into a license agreement with Community IQ.com d/b/a Vista.com(“Vista”).  Under the agreement, theCompany acquired an exclusive license from Vista to sell and market Vista’s webservices solutions to the Company’s channel partners.  The Company prepaid $100,000 of royalties under the license agreementand advanced $250,000 to Vista in connection with a right to purchase 3,313,000shares of Vista’s Series C convertible preferred stock for $500,000 (seebelow).  Additionally, the Companyacquired a $1,000,000 convertible note receivable payable by Vista bearinginterest at 8 percent and due August 15, 2003.  The $1,000,000 note receivable was acquired from Vista’s founderand majority stockholder in exchange for 800,000 shares of the Company’s commonstock (which had an estimated fair value of $900,000) and $100,000 incash.  The note receivable is guaranteedby Vista’s founder and majority stockholder and is convertible at the Company’soption into a 20 percent fully diluted interest in Vista.

 

In December 2002, theCompany and Vista entered into a Stock Purchase Agreement, pursuant to whichthe Company acquired 3,313,000 shares of Vista’s Series C preferred stock for$500,000.  The 3,313,000 shares ofSeries C preferred stock represent a 10 percent fully diluted interest inVista.  The $250,000 advance discussedabove was applied toward the purchase and the remaining $250,000 was paid inJanuary 2003.  Additionally, theCompany and Vista entered into an Agreement and Plan of Merger pursuant towhich the Company received an option through March 31, 2003 to acquire theremaining 70 percent ownership interest of Vista in exchange for 2,500,000shares of the Company’s common stock. The Company also received the right to representation on Vista’s boardof directors.  The option to purchasethe remaining 70 percent of Vista expired unexercised on March 31, 2003.

 

In January 2003, theCompany advanced Vista $100,000 in the form of a promissory note due onApril 14, 2003.  On April 2,2003, the maturity date on this promissory note was extended to April 30,2003.  This promissory note bears interestat 8 percent payable at maturity and is convertible at the Company’s optioninto a 5 percent fully diluted interest in Vista.  On April 2, 2003, the Company advanced Vista an additional$100,000 in the form of a promissory note due on April 30, 2003.  The promissory note bears interest at 8percent payable at maturity and is convertible at the Company’s option into a 5percent fully diluted interest in Vista.

 

As of July 31, 2003,the $1,000,000 convertible note receivable discussed above as well as both$100,000 notes receivable were outstanding and in technical default; however,the Company had not demanded repayment. No allowance for the past due notes receivable was recorded as

 

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ofJuly 31, 2003 since the Company and Vista continue to work together underthe license agreement discussed above and the Company is evaluating its optionto convert the notes receivable to equity in Vista.

 

As a result of the Company’scurrent 10 percent ownership interest in Vista, the right to representation onVista’s board of directors, and the convertible features of the notesreceivable from Vista, the Company has accounted for its interest in Vistausing the equity method of accounting.  Under theequity method, the Company recognizes a portion of the net income or net lossof Vista in its consolidated statements of operations based on its ownershipinterest.  Accordingly, during the threeand nine months ended July 31, 2003, the Company recognized $71,000 and$171,000, respectively, of equity in loss of affiliate.

 

### **(6)OTHER CURRENT LIABILITIES**

### ** **

As ofJuly 31, 2003 and October 31, 2002, other current liabilitiesconsisted of the following (in thousands):

 
|                                          |   | **July 31,  2003** |   | **October 31,  2002** |   |
|-----------------------------------------------|--------|-------------------------|--------|----------------------------|--------|
|                                          |   |                    |   |                       |   |
| Co-operative  advertising                     |   | $                       | 1,265  |                       | $      | 1,630 |   |
| Accrual  for unvouchered payables             |   | 1,441                   |   | 1,824                      |   |
| Restructuring  accrual – current portion |   | 420                     |   | 1,113                      |   |
| Other                                         |   | 2,433                   |   | 3,065                      |   |
| Total                                         |   | $                       | 5,559  |                       | $      | 7,632 |   |

 

**(7)RESTRUCTURING PLANS**

 

The Company’s board of directors has adoptedrestructuring plans to reduce facilities and personnel costs.  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.  During the three months ended July 31,2003, the Company notified approximately 35 employees, or approximately 10percent of the Company’s workforce, that their employment would be terminated.  In connection with this action, the Companyincurred a restructuring charge of $614,000 that related to severance paymentsfor these former employees.

 

In March 2003, in connection with management’sdecision to establish strategic European headquarters in Dublin, Ireland, andthe Company’s United Kingdom (“UK”) subsidiary, SCO Group, Ltd., not performingat expected levels, the Company determined that the operations of SCO Group,Ltd. would be wound up.  OnMarch 26, 2003, the board of directors of SCO Group, Ltd., obtainedadministrative relief in accordance with Rule 2.2 of the Insolvency Rules 1986of the UK.  In connection with theapproved administrative relief, the operations of SCO Group, Ltd. weretransferred to an administrator that was appointed by the court to complete thewinding-up process.  As of April 30,2003, the operations of SCO Group, Ltd. were no longer under the control of theCompany and the Company had been released of any liabilities in exchange forthe net assets of SCO Group, Ltd.  TheCompany has included the operating results of SCO Group, Ltd. throughApril 30, 2003, in the accompanying condensed consolidated statement ofoperations.  Since SCO Group Ltd.’soperations ceased on April 30, 2003, there are no operating resultsincluded in the accompanying condensed consolidated statement of operations forthe three months ended July 31, 2003.

 

In connection with the winding-up of SCO Group, Ltd.’soperations, the Company incurred charges for severance and related payments foremployees totaling $972,000.  As aresult of the administrative relief and transfer of SCO Group, Ltd. to theadministrator, the Company reversed $836,000 of previously recorded accrualsrelated to the leased facilities in the UK, of

 

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which $415,000 wasrecorded in connection with the Tarantella Acquisition.  The winding-up of SCO Group Ltd. resulted ina net restructuring charge during the quarter ended April 30, 2003 of$136,000.

 

The following table summarizes the activity related tothe restructuring accruals during the nine months ended July 31, 2003 (inthousands):

 
|                                                             |   | **Balance as  of  October 31,  2002** |   | **Additions** |   | **Payments** |   | **Adjustments** |   | **Balance as  of  July 31,  2003** |   |
|------------------------------------------------------------------|--------|--------------------------------------------|--------|---------------|--------|--------------|--------|-----------------|--------|-----------------------------------------|--------|
|                                                             |   |                                       |   |          |   |         |   |            |   |                                    |   |
| Restructuring  accrual during   quarter ended Oct. 31, 2001 |   | $                                          | 183    |          | $      | —       |   | $               | (80    | )                                       | $      | (103 | ) | $ | — |   |
| Restructuring  accrual during   quarter ended Jan. 31, 2002 |   | 463                                        |   | —        |   | (42          | )      | (421            | )      | —                                  |   |
| Restructuring  accrual during   quarter ended July 31, 2002 |   | 180                                        |   | —        |   | (178         | )      | (2              | )      | —                                  |   |
| Restructuring  accrual during   quarter ended Oct. 31, 2002 |   | 961                                        |   | —        |   | (414         | )      | (147            | )      | 400                                     |   |
| Restructuring  accrual during   quarter ended Apr. 30, 2003 |   | —                                     |   | 972           |   | (972         | )      | —          |   | —                                  |   |
| Restructuring  accrual during   quarter ended July 31, 2003 |   | —                                     |   | 614           |   | (403         | )      | —          |   | 211                                     |   |
| Total                                                            |   | $                                          | 1,787  |          | $      | 1,586        |   | $               | (2,089 | )                                       | $      | (673 | ) | $ | 611 |   |

 

The adjustments related to the July 31, 2002 andOctober 31, 2002 accruals totaling $149,000 represent the differencebetween actual payments made and estimated accruals for severance costs forinternational employees.  Theadjustments related to the October 31, 2001 and January 31, 2002accruals totaling $524,000 represent facilities accruals reversed as theCompany was successful in negotiating lease terminations for two of itsfacilities (one in the United States and one in the UK as discussed above) thathad been vacated in connection with previous corporate restructurings.

 

At the time of the restructurings discussed above, theaccruals recorded were management’s best estimate of the future costs.  As of July 31, 2003, the remainingaccrual relates primarily to payments to terminated employees which will bepaid during the quarter ending October 31, 2003, and for future leasepayments for vacated facilities that will be relieved as the lease payments aremade in accordance with the lease terms through 2005.

 

**(8) COMMITMENTS AND CONTINGENCIES**

 

**Litigation**

 

*IBM*

 

On or about March 6, 2003, the Company filed a complaint against IBMalleging breach of contract, misappropriation of trade secrets, tortiousinterference, and unfair competition. The complaint centers on IBM’s activities regarding the UNIX operatingsystem that underlies both the Company’s UNIX-based operating systems and IBM’sAIX, its UNIX-based operating system. The complaint alleges that IBM obtained information concerning the UNIXsource code from the Company and inappropriately used and distributed thatinformation in connection with its efforts to promote the Linux operatingsystem.  The complaint seeks damages inexcess of $1 billion.  On or aboutJune 13, 2003, the Company provided IBM notice that IBM’s UNIX licenseagreement with the Company that underlies IBM’s AIX software was revoked.

 

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On or about June 16,2003, the Company filed an amended complaint in the IBM case.  The amended complaint essentially restatesand realleges the allegations of the original complaint and expands on thoseclaims.  Most importantly, the amendedcomplaint raises new allegations regarding IBM’s actions and breaches throughthe actions of Sequent Computer Systems, Inc. (“Sequent”) which 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 aresponse and counter claim to the complaint, including a demand for a jurytrial.  The discovery process of theaction has just commenced.  The actionhas been removed from Utah Third District State Court and is currently pendingin the Federal District Court for the District of Utah.

 

In its counter claim, IBM asserts that the Companydoes not have the right to terminate IBM’s UNIX license or assert claims basedon the Company’s ownership of UNIX intellectual property against IBM or othersin the Linux community.  In addition,IBM asserts that the Company has infringed on certain patents held by IBM.  IBM’s counter claims include claims forbreach of contract, violation of the Lanham Act, unfair competition,intentional interference with prospective economic relations, unfair anddeceptive trade practices, breach of the GNU general public license, and patentinfringement.  The Company intends tovigorously defend against these counter claims.

 

*Red Hat, Inc.*

 

On or about August 4, 2003, Red Hat, Inc. (“RedHat”) filed a complaint against the Company in the United States District Courtfor the 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 aboutSeptember 15, 2003, the Company filed a motion to dismiss the Red Hatcomplaint.  The motion to dismissasserts that Red Hat lacks standing and that no case or controversy exists withrespect to the claims seeking a declaratory judgment of non-infringement.  The motion to dismiss further asserts thatRed Hat’s claims under the Lanham Act and related state laws are barred by theFirst Amendment to the U.S. Constitution and the common law privilege ofjudicial immunity.

 

*IPO Matter*

 

Beginning in July 2001, the Company, certain ofits officers and directors, and the underwriters of the Company’s initialpublic offering were named as defendants in a series of class action lawsuitsfiled in the United States District Court for the Southern District of New York(the “Actions”) by parties alleging violations of the securities laws. Thecomplaints were subsequently amended and consolidated into a single complaint.

 

The consolidated complaint alleges certainimproprieties regarding the circumstances surrounding the underwriters’ conductduring the Company’s initial public offering and the failure to disclose suchconduct in the registration statement in violation of the Securities Act of1933, as amended.  The consolidatedcomplaint also alleges that, whether or not the Company’s officers or directorswere aware of the underwriters’ conduct, the Company and those officers anddirectors have statutory liability under the securities laws for issuing aregistration statement in connection with the Company’s initial public offeringthat failed to disclose that conduct. The

 

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consolidatedcomplaint also alleges claims solely against the underwriters under theSecurities Act of 1933 and the Securities Exchange Act of 1934, asamended.  Over 300 other issuers, andtheir underwriters and officers and directors, have been sued in similar casespending in the same court.

 

In September 2002, the plaintiffs agreed todismiss the individual defendants, but may elect to bring the individualdefendants back into the case at a later date. The Company is not aware of any improper conduct by the Company, itsofficers and directors, or its underwriters, and the Company denies anyliability relating thereto.  Inaddition, the underwriting agreement provides for the indemnification of theCompany and its officers and directors for liabilities arising out ofmisstatements in its registration statement attributable to materialnon-disclosures by the underwriters. The Company also maintains liability insurance coverage that is expectedto substantially cover the costs of defending the claims in excess of theretention amount.

 

The plaintiffs, issuers and the insurance companieshave negotiated a Memorandum of Understanding (“MOU”) with the intent ofsettling the dispute between the plaintiffs and the issuers.  The Company has executed the MOU and hasbeen 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 settlementagreements.  If the settlement is approvedand appropriate settlement agreements can be entered into by the parties, andif no cross-claims, counter claims or third party claims are later asserted,this action will be dismissed with respect to the Company and the individualdefendants.

 

The Company has notified its underwriters andinsurance companies of the existence of the claims.  Management believes, after consultation with legal counsel, thatthe ultimate outcome of this matter will not have a material adverse effect onthe Company’s results of operations or financial position.  As of July 31, 2003, the Company has paidor accrued the full retention amount of $200,000under its insurance coverage.

 

*OtherMatters*

 

In April 2003, a former Indian distributor of theCompany filed a claim in India, requesting summary judgment for payment of$1,428,000, and an order that the Company trade in India only through thedistributor until the claim is paid. The distributor claims that the Company isresponsible to repurchase certain software products and to reimburse thedistributor for certain other operating costs. Management does not believe thatthe Company is responsible to reimburse the distributor for any operating costsand also believes that the return rights related to any remaining inventoryhave lapsed. In accordance with the Company’s revenue recognition policy,revenue related to the inventory held by the distributor is included indeferred revenue as of July 31, 2003. Management has 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. An initial hearing has been scheduled forSeptember 2003. Management believes, after consultation with legalcounsel, that the ultimate outcome of this matter will not have a material adverseeffect on the Company’s results of operations or financial position.

 

The Australian Competition and Consumer Commission(the “ACCC”) has contacted the Company and requested information regardingcomplaints it has received regarding the Company’s intellectual property claimsand the Company’s statements regarding the need for commercial Linux users toobtain a UNIX license.  The Company intends to respond to the ACCC’sinquiry.  The ACCC has notified the Company that it has not made any decisionto pursue the complaints it has received or determined what, if any, action itwill take.

 

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Several entities in Germany have obtained temporaryrestraining orders in Germany precluding SCO GmbH, the Company’s German subsidiary,in substance, from making statements in Germany that disparage Linux, orentities involved in the Linux business, or implicate Linux as infringing theCompany’s intellectual property rights.  SCO GmbH has received anadministrative fine of 10,000 Euro for a technical violation of one of thetemporary restraining orders.  The Company is currently negotiating withthe various claimants in Germany over the temporary restraining orders and isevaluating whether it will appeal the administrative fine.  Informalletter complaints similar to those raised in Germany have been received fromcompanies in Austria and Poland.  TheCompany has responded to those letters. It is not known if those complainants will take future action.

 

Pursuit and defense of the above-mentioned matterswill be costly, and management expects the costs for legal fees and relatedexpenses may be substantial.  Theultimate outcome or potential effect of the Company’s results of operations orfinancial position as a result of the above-mentioned matters is not currentlyknown or determinable.

 

The Company is a party to certain other legalproceedings arising in the ordinary course of business including legalproceedings arising from its SCOsource initiative.  Management believes, after consultation with legal counsel, thatthe ultimate outcome of such legal proceedings will not have a material adverseeffect on the Company’s results of operations or financial position.

 

**(9) STOCKHOLDERS’ EQUITY**

 

**Stock-Based Compensation**

 

The following table details the components ofstock-based compensation for the three and nine months ended July 31, 2003and 2002 (in thousands):

 
|                                                |   | **Three  Months Ended July 31,** |   | **Nine  Months Ended July 31,** |       |
|-----------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|------------|
|                                                |   | **2003**                              |   | **2002**                             | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                |   |                                  |   |                                 |       |   |   |   |   |
| Amortization  (benefit) of stock-based compensation |   | $                                     | 235    |                                 | $          | (287 | ) | $ | 631 |   | $ | 144 |   |
| Option  to consultant                               |   | 74                                    |   | —                               |       | 260 |   | — |   |
| Options  and shares for services                    |   | —                                |   | 198                                  |       | 36 |   | 311 |   |
| Modifications  to options                           |   | —                                |   | —                               |       | — |   | 73 |   |
| Total                                               |   | $                                     | 309    |                                 | $          | (89 | ) | $ | 927 |   | $ | 528 |   |

 

During the three and nine months ended July 31,2003, the Company granted options to purchase 375,000 and 1,488,000 shares ofcommon stock with average exercise prices of $8.53 and $3.58, respectively, pershare.  None of these stock options wasgranted at prices below the quoted market price on the date of grant.  During the three and nine months endedJuly 31, 2003, 776,000 and 1,023,000 options to purchase shares of commonstock were exercised with average exercise prices of $1.57 and $1.41 per share,respectively.  As of July 31, 2003,there were 3,724,000 stock options outstanding with a weighted average exerciseprice of $2.82 per share.

 

Amortization of stock-based compensation was $235,000and $631,000, during the three and nine months ended July 31, 2003,respectively.  Amortization (benefit) ofstock-based compensation was ($287,000) and $144,000, during the three and ninemonths ended July 31, 2002 respectively. The benefit of stock-based compensation for the three months endedJuly 31, 2002 resulted from the reversal of previously recordedstock-based compensation related to non-vested options forfeited by certainemployees whose employment had been terminated.

 

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During the three and nine months ended July 31,2003, the Company issued 7,000 and 225,000 shares, respectively, of restrictedstock to certain key employees.  Therestrictions on the restricted stock awards granted to key employees lapse overa period of 24 months.  The fair valueof the restricted stock awards granted for the three and nine months endedJuly 31, 2003, was $61,000 and $415,000, respectively.  The fair value of the restricted stockawards was recorded as a component of deferred compensation and is amortized tostock-based compensation as the restrictions lapse.

 

During the quarter ended April 30, 2003, theCompany’s board of directors approved a resolution to receive remaining amountsowed to them for services provided during the 2002 fiscal year in the form ofstock awards.  The Company issued 27,500shares of common stock with a fair value of $36,000.  The fair value of the stock was recorded as stock-basedcompensation for the nine months ended July 31, 2003.  Additionally, the Company granted 150,000shares of restricted common stock to members of the Company’s board ofdirectors with a fair value of $195,000. The restricted common stock issued to the board of directors was in lieuof cash compensation for their services to the Company during the 2003 fiscalyear and the restrictions lapse on October 31, 2003.

 

In December 2002, the Company issued a ten-yearoption to a consultant to acquire 100,000 shares of the Company’s common stockat $1.52 per share.  The option vests asfollows, (i) options to purchase 50,000 shares vest on a monthly basis over a12-month period, and (ii) the remaining options to purchase 50,000 shares vestupon the achievement of certain milestones. The fair value of the options will be determined and recorded as expensein the periods the services are performed and the milestones are achieved.  During the quarter ended July 31, 2003,the Company recorded $74,000 of expense related to this option.  Assumptions used in the Black-Scholesoption-pricing model to determine the fair value of the options vested duringthe quarter ended July 31, 2003 were the following: market value of commonstock of $7.34 per share; risk-free interest rate of two percent; expecteddividend yield of 0 percent; volatility of 232 percent; and expected exerciselife of one year.  For the nine monthsended July 31, 2003, the Company recorded $260,000 of expense related tothis option.

 

**Warrant Agreement**

 

During the quarter ended April 30, 2003, theCompany issued a warrant to a SCOsource licensee.  The warrant allows the licensee to acquire 210,000 shares of theCompany’s common stock at an exercise price of $1.83 per share for a term offive years from the date of grant. Because the warrant was issued for no consideration to the SCOsource licensee,the Company has recorded the fair value of the warrant of $500,000, asdetermined using the Black-Scholes option-pricing model, as a warrantoutstanding during the quarter ended April 30, 2003 and reduced licenserevenue accordingly.  Assumptions usedin the Black-Scholes option-pricing model to estimate fair value were thefollowing: market value of common stock of $2.40 per share; risk-free interestrate of three percent; expected dividend yield of 0 percent; volatility of 236percent; and term of five years.

 

During the quarter ended July 31, 2003, theCompany issued a second warrant to the above mentioned SCOsource licensee inconnection with payment of amounts owed to the Company under the initiallicense agreement.  The warrant allowsthe licensee to acquire 12,500 shares of the Company’s common stock at anexercise price of $1.83 per share for a term of five years from the date of theagreement.  Because the warrant wasissued in connection with the advance payment, the Company has recorded thefair value of the warrant of $150,000, as determined using the Black-Scholesoption-pricing model, as a warrant outstanding and reduced license revenueaccordingly.  Since the terms of theinitial license agreement extended beyond the Company’s normal payment terms,the related revenue was not recognized until the payments

 

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became due.  Assumptions used in the Black-Scholesoption-pricing model to estimate the fair value were the following: marketvalue of common stock of $12.52 per share; risk-free interest rate of twopercent; expected dividend yield of 0 percent; volatility of 137 percent; and aterm of five years.

 

**Warrant Agreement with Consultant**

 

During the quarter ended July 31, 2003, theCompany issued a warrant to a consultant, as part of an agreement to assist theCompany with its SCOsource licensing initiative.  The warrant allows the consultant to acquire 25,000 shares of theCompany’s common stock at an exercise price of $8.50 per share for a term oftwo years from the date of the agreement. The Company has recorded the fair value of the warrant of $94,000, asdetermined using the Black-Scholes option-pricing model, as a warrantoutstanding and included this cost as a cost of SCOsource licensingrevenue.  Assumptions used in the Black-Scholesoption-pricing model to estimate the fair value were the following: marketvalue of common stock of $12.84 per share; risk-free interest rate of twopercent; expected dividend yield of 0 percent; volatility of 143 percent; and aterm of 2 years.

 

**Warrant Agreement with Morgan Keegan**

 

In August 2002, theCompany entered into an agreement with Morgan Keegan & Company (“MorganKeegan”) to act as an exclusive financial advisor to assist the Company in itsanalysis, consideration and if appropriate, execution of various financial andstrategic alternatives including, but not limited to, securing additionalequity and/or debt capital and potential strategic transactions includingmergers, acquisitions and joint ventures.

 

In consideration for theservices provided, the Company issued to Morgan Keegan a warrant to purchase200,000 shares of the Company’s common stock at an exercise price of $0.01 pershare.  Morgan Keegan was granted demandregistration rights to have the Company use its best efforts to register theshares upon exercise of the warrant. The Company expensed the fair value of the warrant of $294,000,determined using the Black-Scholes option-pricing model.  Assumptions used in the Black-Scholesoption-pricing model were the following: market value of common stock of $1.47per share; risk-free interest rate of three percent; expected dividend yield of0 percent; volatility of 145 percent; and expected exercise life of threemonths.  In January 2003, MorganKeegan exercised the warrant.

 

In the event that theCompany is successful in raising equity, it will owe a contingent fee to MorganKeegan for six percent of the principal amount of the financing.  If the Company is successful in raisingmezzanine financing (convertible debt) and/or senior debt, it will owe acontingent fee to Morgan Keegan of three percent and one percent, respectively,of the amounts borrowed.  In the eventthat the Company is successful in completing an acquisition, it will owe a contingentfee to Morgan Keegan for the greater of two percent of the transaction value or$250,000.

 

**Employee Stock Purchase Plan**

 

On November 30, 2002, employees participating inthe Company’s employee stock purchase plan acquired 87,500 shares of theCompany’s common stock at a price of $0.66 per share.  On May 31, 2003, 258,000 shares of the Company’s commonstock were acquired at prices between $0.66 and $1.38 per share.

 

**(10) AGREEMENT WITH CENTER 7, INC.**

 

On April 30, 2003, the Company and Center 7, Inc.(“C7”) entered into a Marketing and Distribution Master Agreement (the“Marketing Agreement”) and an Assignment Agreement.  C7 is majority owned by Canopy. Under the Marketing Agreement, the Company was appointed

 

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as a worldwide distributorfor C7 products and will co-brand, market and distribute these products.  The Company will pay C7 a royalty on allproducts sold.  Under the AssignmentAgreement, the Company assigned C7 the copyright applications, trademarks,patents and contracts related to Volution Manager, Volution Authentication,Volution Online and Volution Manager Update Service (collectively, the“Assigned Software”).  As considerationfor this assignment, C7 issued to the Company a $500,000 non-recoursepromissory note, secured by the Assigned Software, due on April 30, 2005with interest payable at a rate of one percent above the prime rate as reportedin the Wall Street Journal.

 

During the time the Company was developing theAssigned Software, it had expensed all amounts for its research and developmentefforts.  As a result, at the time thepromissory note was executed, the Company had no recorded basis in the AssignedSoftware.  Because the transfer of theAssigned Software was to a related party in exchange for a promissory note, nogain will be recognized by the Company until payments are received.

 

**(11)SIGNIFICANT CUSTOMERS**

 

During the three months ended July 31, 2003,Microsoft Corporation (“Microsoft”) accounted for approximately 25 percent oftotal revenue and Sun Microsystems, Inc. (‘Sun”) accounted for approximately 12percent of total revenue.  During thenine months ended July 31, 2003, Microsoft accounted for approximately 16percent of total revenue and Sun accounted for approximately 12 percent, oftotal revenue.  There were nooutstanding receivables from these two customers as of July 31, 2003.  During the three and nine months endedJuly 31, 2002, the Company did not have any customers that accounted formore than 10 percent of total revenue.

 

**(12) SEGMENT INFORMATION**

 

The Company’s resources are allocated and operatingresults managed to the operating income (loss) level for each of the Company’sthree geographic units.  The geographicunits consist of the Americas, EMEA (Europe, Middle East and Africa) and Asia.  Revenue, cost of revenue and direct salesand marketing expenses are tracked for each geographic unit.  Costs of corporate marketing, research anddevelopment and general and administration are allocated to each geographicunit based on the geographic unit’s percentage of total revenue.  Corporate revenue and cost of revenueprimarily includes amounts related to the Company’s SCOsource licensingdivision and other amounts not allocated to specific geographic units.

 

Segment disclosures for the Company’s operatingdivisions are as follows for the three and nine months ended July 31, 2003and 2002 (in thousands):

 
|                           |   | **Three  Months Ended July 31, 2003** |   |
|--------------------------------|--------|--------------------------------------------|--------|
|                           |   | **Americas**                               |   | **EMEA** |   | **Asia** |   | **Corporate** |   | **Total** |   |
|                           |   |                                       |   |   |   |   |   |   |   |   |   |
| Revenue                        |   | $                                          | 7,003  |   | $ | 4,673 |   | $ | 1,117 |   | $ | 7,262 |   | $ | 20,055 |   |
| Cost  of revenue               |   | 1,479                                      |   | 903 |   | 217 |   | 1,935 |   | 4,534 |   |
| Gross  margin                  |   | 5,524                                      |   | 3,770 |   | 900 |   | 5,327 |   | 15,521 |   |
| Sales  and marketing           |   | 2,363                                      |   | 2,849 |   | 718 |   | — |   | 5,930 |   |
| Research  and development      |   | 1,616                                      |   | 1,078 |   | 256 |   | — |   | 2,950 |   |
| General  and administrative    |   | 775                                        |   | 516 |   | 122 |   | — |   | 1,413 |   |
| Other                          |   | —                                     |   | — |   | — |   | 1,818 |   | 1,818 |   |
| Total  operating expenses      |   | 4,754                                      |   | 4,443 |   | 1,096 |   | 1,818 |   | 12,111 |   |
| Income  (loss) from operations |   | $                                          | 770    |   | $ | (673 | ) | $ | (196 | ) | $ | 3,509 |   | $ | 3,410 |   |

 

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|                        |   | **Three  Months Ended July 31, 2002** | ** ** |
|-----------------------------|--------|--------------------------------------------|------------|
|                        |   | **Americas**                               |       | **EMEA** | ** ** | **Asia** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                        |   |                                       |       |   |   |   |   |   |   |   |   |
| Revenue                     |   | $                                          | 7,928      |   | $ | 5,376 |   | $ | 2,080 |   | $ | — |   | $ | 15,384 |   |
| Cost  of revenue            |   | 2,142                                      |       | 1,508 |   | 421 |   | — |   | 4,071 |   |
| Gross  margin               |   | 5,786                                      |       | 3,868 |   | 1,659 |   | — |   | 11,313 |   |
| Sales  and marketing        |   | 2,949                                      |       | 2,887 |   | 1,072 |   | — |   | 6,908 |   |
| Research  and development   |   | 2,208                                      |       | 1,497 |   | 579 |   | — |   | 4,284 |   |
| General  and administrative |   | 1,165                                      |       | 790 |   | 305 |   | — |   | 2,260 |   |
| Other                       |   | —                                     |       | — |   | — |   | 2,103 |   | 2,103 |   |
| Total  operating expenses   |   | 6,322                                      |       | 5,174 |   | 1,956 |   | 2,103 |   | 15,555 |   |
| Loss  from operations       |   | $                                          | (536       | ) | $ | (1,306 | ) | $ | (297 | ) | $ | (2,103 | ) | $ | (4,242 | ) |

 
|                           |   | **Nine  Months Ended July 31, 2003** | ** ** |
|--------------------------------|--------|-------------------------------------------|------------|
|                           |   | **Americas**                              |       | **EMEA** | ** ** | **Asia** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                           |   |                                      |       |   |   |   |   |   |   |   |   |
| Revenue                        |   | $                                         | 20,977     |   | $ | 14,218 |   | $ | 4,097 |   | $ | 15,672 |   | $ | 54,964 |   |
| Cost  of revenue               |   | 4,195                                     |       | 3,023 |   | 756 |   | 4,585 |   | 12,559 |   |
| Gross  margin                  |   | 16,782                                    |       | 11,195 |   | 3,341 |   | 11,087 |   | 42,405 |   |
| Sales  and marketing           |   | 7,373                                     |       | 8,554 |   | 2,484 |   | 10 |   | 18,421 |   |
| Research  and development      |   | 4,339                                     |       | 2,937 |   | 835 |   | 31 |   | 8,142 |   |
| General  and administrative    |   | 2,407                                     |       | 1,632 |   | 467 |   | 19 |   | 4,525 |   |
| Other                          |   | —                                    |       | — |   | — |   | 3,720 |   | 3,720 |   |
| Total  operating expenses      |   | 14,119                                    |       | 13,123 |   | 3,786 |   | 3,780 |   | 34,808 |   |
| Income  (loss) from operations |   | $                                         | 2,663      |   | $ | (1,928 | ) | $ | (445 | ) | $ | 7,307 |   | $ | 7,597 |   |
|                           |   |                                      |       |   |   |   |   |   |   |   |   |

 
|                        |   | **Nine  Months Ended July 31, 2002** | ** ** |
|-----------------------------|--------|-------------------------------------------|------------|
|                        |   | **Americas**                              |       | **EMEA** | ** ** | **Asia** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                        |   |                                      |       |   |   |   |   |   |   |   |   |
| Revenue                     |   | $                                         | 24,755     |   | $ | 18,406 |   | $ | 5,612 |   | $ | — |   | $ | 48,773 |   |
| Cost  of revenue            |   | 9,502                                     |       | 4,459 |   | 1,246 |   | — |   | 15,207 |   |
| Gross  margin               |   | 15,253                                    |       | 13,947 |   | 4,366 |   | — |   | 33,566 |   |
| Sales  and marketing        |   | 9,933                                     |       | 9,454 |   | 3,557 |   | — |   | 22,944 |   |
| Research  and development   |   | 7,010                                     |       | 5,215 |   | 1,585 |   | — |   | 13,810 |   |
| General  and administrative |   | 3,750                                     |       | 2,795 |   | 849 |   | — |   | 7,394 |   |
| Other                       |   | —                                    |       | — |   | — |   | 11,015 |   | 11,015 |   |
| Total  operating expenses   |   | 20,693                                    |       | 17,464 |   | 5,991 |   | 11,015 |   | 55,163 |   |
| Loss  from operations       |   | $                                         | (5,440     | ) | $ | (3,517 | ) | $ | (1,625 | ) | $ | (11,015 | ) | $ | (21,597 | ) |

 

Long-lived assets, which include property andequipment as well as intangible assets and goodwill, by location consists ofthe following as of July 31, 2003 and October 31, 2002 (inthousands):

 
|                    |   | **July 31,  2003** |   | **October 31,    2002** |   |
|-------------------------|--------|-------------------------|--------|------------------------------|--------|
| Long-lived assets:      |   |                    |   |                         |   |
| United States           |   | $                       | 12,488 |                         | $      | 12,866 |   |
| International           |   | 504                     |   | 413                          |   |
| Total long-lived assets |   | $                       | 12,992 |                         | $      | 13,279 |   |

 

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| **ITEM 2****.** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION  AND RESULTS OF OPERATIONS** |
|-----------------|-------------------------------------------------------------------------------------------------|

 

The following discussion should be read in conjunctionwith our condensed consolidated financial statements and notes thereto,included elsewhere in this quarterly filing and our annual report on Form 10-Kfor the year ended October 31, 2002 filed with the Securities and ExchangeCommission, including the audited financial statements and management’sdiscussion and analysis contained therein. This discussion contains forward-looking statements that involve risksand uncertainties often indicated by such words as “estimates,” “anticipates,”“continues,” “expects,” “intends,” “believes” and similar expressions.  Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result ofvarious factors, including those set forth below under “Forward-LookingStatements” and “Risk Factors” and elsewhere in this quarterly filing.

 

**Overview**

 

We originally incorporated as Caldera Systems, Inc.(“Caldera Systems”), a Utah corporation 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.  OnMay 7, 2001, we formed a new holding company in Delaware under the name ofCaldera International, Inc. to acquire substantially all of the assets andoperations of the server and professional services groups of Tarantella Inc.(“Tarantella”), formerly known as The Santa Cruz Operation, Inc.  In connection with this acquisition, CalderaSystems became a wholly-owned subsidiary of Caldera International, Inc.  Former holders of shares and optionsto purchase shares of Caldera Systems received an equal number of shares andoptions to purchase shares in Caldera International, Inc.

 

On May 16, 2003, ourstockholders approved our corporate name change to The SCO Group, Inc. (“SCO”or the “Company”).  We adopted this namechange in response to the continuing brand recognition related to the SCOOpenServer and SCO UnixWare product lines. As used herein, the “Company” or “us,” “we,” “ours,” or similar termsrefer to The SCO Group, Inc. and our operating subsidiaries.

 

**Recent Developments**

 

During the quarter ended July 31, 2003, wecompleted the acquisition of the assets of Vultus, Inc. a company engaged inthe web services interface business in exchange for the issuance of 305,274shares.  We assumed liabilities ofapproximately $215,000 in connection with the acquisition, and extendedemployment offers to substantially all of Vultus’ prior employees.  We anticipate that the acquired technologyand expertise will contribute to the products and services we intend to offerunder our web services strategy.

 

During recent quarters, we have experienced a declinein our product and services revenue primarily attributed to the worldwideeconomic slowdown, lower information technology spending and increasedcompetition in the operating system market. However, we have implemented cost reduction measures to decreasepersonnel and excess facilities costs and have significantly reduced ouroverall operating expenses.  Thesemeasures, combined with revenue of $15,530,000 from our SCOsource licensinginitiative, have resulted in the first two profitable quarters in our history.

 

Among the assets we acquired from Tarantella, weresource code, copy rights and contracts to UNIX.  These rights had initially been developed by AT&T Bell Labsand include over 30,000 licensing and sublicensing agreements that have beenentered into with approximately 6,000 entities.  These licenses led to the development of several proprietaryUNIX-based operating systems, including but not limited to our own SCO UnixWareand SCO OpenServer,

 

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Sun’s Solaris, IBM’s AIX,SGI’s IRIX, HP’s UX, Fujitsu’s ICL DRS/NX, Siemens’ SINIX, Data General’sDG-UX, and Sequent’s DYNIX/Ptx.  Webelieve these operating systems are all derivatives of the original UNIX sourcecode owned by us.

 

We initiated the SCOsource effort to review the statusof these existing licensing and sublicensing agreements and to identify othersin the industry that may be currently using our intellectual property withoutobtaining the necessary licenses.  Thiseffort resulted in the execution of two license agreements during theApril 30, 2003 quarter.  The firstof these licenses was with Sun Microsystems, Inc. (“Sun”), a long-time licenseeof the UNIX source code and a major participant in the UNIX industry, and was a“clean-up” license to cover items that were outside the scope of Sun’s initialUNIX license.  The second license was toMicrosoft Corporation (“Microsoft”), and covers Microsoft’s UNIX compatibleproducts, subject to certain specified limitations.  The Sun and Microsoft license agreements are non-exclusive,perpetual, paid up licenses to utilize the UNIX source code.

 

The amount that we receive from any such licensee willgenerally depend on the license rights that the licensee previously held andthe amount and level of our intellectual property the licensee desires tolicense.  The two licensing agreementssigned by us to date resulted in revenue of $8,250,000 during theApril 30, 2003 quarter and $7,280,000 during the July 31, 2003quarter.  The license agreement with Sunprovides for an additional $2,500,000 to be paid to us byNovember 2003.  On July 31,2003, Microsoft exercised an option to acquire expanded licensing rights.  Upon delivery, we expect to recognizeadditional revenue related to this option.

 

In connection with the payment of $2,500,000 to us bySun during the quarter ended July 31, 2003, we granted a warrant to Sun topurchase up to 12,500 shares of our common stock, for a period of five years,at a price of $1.83 per share.  Thiswarrant was valued at $150,000 using the Black-Scholes option-pricing model andreduced our licensing revenue for the quarter ended July 31, 2003 by thatamount.

 

During the course of the review of our intellectualproperty rights, we became concerned generally about the existence of UNIXsource code in the Linux operating system. We have alleged that UNIX source code and unauthorized derivatives ofUNIX source code are prevalent in Linux. In March 2003, we filed a complaint against IBM alleging, in part,that it had breached its license agreement with us by, among other things,inappropriately contributing UNIX source code to the open source community andseeking to use its knowledge and methods with respect to UNIX source code andderivative works and modifications licensed to it to destroy the value of theUNIX operating system in favor of promoting the adoption by businesses of theLinux operating system, of which it has been a major backer.  Based on these breaches, we terminated thelicense agreement we have with IBM that permitted the use of our UNIX sourcecode in the development of IBM’s AIX operating system.  In May 2003, we sent letters to approximately1,500 large corporations notifying them that the use of the Linux operatingsystem may be a violation of our intellectual property rights.

 

Subsequent to July 31, 2003, we terminated theUNIX license agreement we had with Sequent Computer Systems, Inc. (“Sequent”)(which was previously acquired by IBM) based on similar breaches we had claimedagainst IBM.  This license was the basisfor Sequent’s UNIX-based offering, the DYNIX /Ptx operating system.

 

InAugust 2003, we were sued by Red Hat Inc. (“Red Hat”), seeking, amongother things, a declaratory judgment that Linux does not infringe on ourintellectual property rights.

 

The success of our SCOsource licensing initiative, atleast initially, will depend to a great extent on the perceived strength of ourintellectual property and contractual claims and our

 

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willingness to enforceour rights.  Many, particularly those inthe open source community, dispute the allegations of infringement that we havemade.

 

While our SCOsource initiative has already resulted inrevenue of $15,530,000 during the last two quarters and we continuenegotiations with other industry participants that we believe may lead toadditional SCOsource license agreements, we are currently unable to predict thelevel or timing of future revenue from this source, if any.

 

THREE AND NINE MONTHSENDED JULY 31, 2003 AND 2002

 

*Revenue*

 

Revenue was $20,055,000 for the thirdquarter of fiscal year 2003, and $15,384,000 for the third quarter of fiscalyear 2002, representing an increase of $4,671,000, or 30 percent.  This increasewas attributable to $7,280,000 in licensing revenue, which was the secondconsecutive quarter we generated revenue from our SCOsource licensinginitiative, offset by a decline in product revenue of $1,835,000 and a declinein services revenue of $774,000. Revenue was $54,964,000 for the first three quarters of fiscal year2003, and $48,773,000 for the first three quarters of fiscal year 2002,representing an increase of $6,191,000, or 13 percent.  This increase wasattributable to $15,530,000 in licensing revenue, offset by a decline inproduct revenue of $7,135,000 and a decline in services revenue of $2,204,000.

 

As discussed above in Recent Developments,we are unable to predict the level of licensing revenue we may recognize infuture periods.  During the first threequarters of fiscal year 2003, our product and service revenue continued to beadversely impacted by the continuing worldwide economic slowdown and from therelated decrease in information technology spending, as well as from increasedcompetition from other operating system products.  Additionally, our SCOsource activities and initiatives andour recent announcements regarding Linux, may be causing customers to lengthentheir purchase and implementation cycle as they contemplate the appropriateoperating platform of the future and assess the current risks related toLinux.  We have also seen a decline inour deferred revenue from October 31, 2002 to July 31, 2003, and as aresult, our future revenue may be adversely impacted.

 

Excluding licensing revenue from SCOsource,revenue from international customers accounted for 45 percent of operatingsystem platform revenue for the third quarter of fiscal year 2003 and 48percent for the third quarter of fiscal year 2002, and revenue frominternational customers accounted for 47 percent of operating system platformrevenue for the first three quarters of fiscal year 2003 and 49 percent for thefirst three quarters of fiscal year 2002. The decrease in international revenue for the third quarter and for thefirst three quarters of fiscal year 2003 compared to the third quarter and forthe first three quarters of fiscal year 2002 is primarily attributable todecreased revenue in our Europe, Middle East and Africa (“EMEA”) region as aresult of the prolonged economic slow down in these areas.

 

*Products.*  Products revenue was $10,804,000 for thethird quarter of fiscal year 2003 and $12,639,000 for the third quarter offiscal year 2002, representing a decrease of $1,835,000, or 15 percent, andrepresenting a slight decrease in products revenue from our second quarter offiscal year 2003.  Products revenue was$33,016,000 for the first three quarters of fiscal year 2003 and $40,151,000for the first three quarters of fiscal year 2002, representing a decrease of$7,135,000, or 18 percent.

 

The decrease in productsrevenue during the third quarter of fiscal year 2003 from the third quarter offiscal year 2002 as well as during the first three quarters of fiscal year 2003from the first three quarters of fiscal year 2002 was attributable to decreased sales of OpenServer and UnixWareproducts primarily resulting from a decrease in information technology spending

 

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caused by the worldwide economic slowdown,increased competition from other alternate operating platforms, and uncertaintyfrom our recent Linux announcement.**** This impact was largely felt in ourdistribution channel in the Americas and Europe.

 

OpenServer and UnixWareproducts continue to be the largest components of our products revenue.  For the third quarter of fiscal year 2003,OpenServer revenue was $5,243,000 or 49percent of total products revenue and UnixWare revenue was $3,343,000 or 31percent of total products revenue.  Forthe first three quarters of fiscal year 2003, OpenServer revenue was$15,734,000 or 48 percent of total products revenue and UnixWare revenue was$10,524,000 or 32 percent of total products revenue.  We recently announced our intentions tocontinue to invest in these core UNIX operating systems and believe that therevenue from these products will continue to represent a significant portion ofour product revenue for the upcoming quarters.

 

*SCOsourceLicensing*.  SCOsourcelicensing revenue was $7,280,000 for the third quarter of fiscal year 2003 and$15,530,000 for the first three quarters of fiscal year 2003 as compared to norevenue for the third quarter of fiscal year 2002 and for the first threequarters of fiscal year 2002.  Thisrevenue is the result of our intellectual property licensing program,SCOsource, launched in January 2003. We initiated SCOsource for the purpose of protecting the significantintellectual property rights we own surrounding the UNIX source code.  The SCOsource licensing revenue in the thirdquarter of fiscal year 2003 represents additional fees associated with twolicenses executed during the April 30, 2003, quarter.  Under the terms of our license agreement withSun, we will receive an additional $2,500,000 by November 2003.  The Microsoft agreement granted Microsoftthe right to acquire expanded licensing rights, which if exercised would resultin additional revenue to us.  OnJuly 31, 2003, Microsoft exercised this option.  Upon delivery, we expect to recognize the additional revenuerelated to this option.

 

*Services.*  Services revenue was $1,971,000 for thethird quarter of fiscal year 2003 and $2,745,000 for the third quarter offiscal year 2002, representing a decrease of $774,000, or 28 percent.  Services revenue was $6,418,000 for thefirst three quarters of fiscal year 2003 and $8,622,000 for the first threequarters of fiscal year 2002, representing a decrease of $2,204,000, or 26percent.  The decrease in servicesrevenue is primarily related to the decrease in our products revenue, since aportion of our services revenue is dependent on products revenue.  We have also experienced a decrease in ourUNIX-related service offerings as a result of service offerings being bundledtogether with competitive operating system products, primarily Linux-relatedofferings.  We also experienced adecrease in professional services revenue as we have seen a decrease in thedemand for custom enterprise-level projects.

 

### ***Cost of Revenue***

 

*Cost of ProductsRevenue.*  Cost of productsrevenue was $1,284,000 for the third quarter of fiscal year 2003 and $1,577,000for the third quarter of fiscal year 2002, representing a decrease of $293,000,or 19 percent.  Cost of products revenueas a percentage of products revenue was 12 percent for the third quarter offiscal year 2003 and 12 percent for the third quarter of fiscal year 2002.  Cost of products revenue was $3,676,000 forthe first three quarters of fiscal year 2003 and $6,398,000 for the first threequarters of fiscal year 2002, representing a decrease of $2,722,000, or 43percent.  Cost of products revenue as apercentage of products revenue was 11 percent for the first three quarters offiscal year 2003 and 16 percent for the first three quarters of fiscal year2002.

 

The decrease in the cost of productsrevenue as a percentage of revenue for the first three quarters of fiscal year2003 compared to that same period of fiscal year 2002 was attributableprimarily to reduced overhead and manufacturing costs resulting from our costreduction efforts and decreased royalties to third party vendors.  For the fourth quarter of fiscal year 2003,we

 

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expect thecost of products revenue as a percentage of products revenue to be consistentwith the third quarter of fiscal year 2003.

 

*Cost of SCOsource LicensingRevenue.* Cost of SCOsource licensing revenue was $1,712,000 for the third quarterof fiscal year 2003 and, $3,875,000 for the first three quarters of fiscal year2003 and $0 for the third quarter of fiscal year 2002 and for the first threequarters of fiscal year 2002.  Cost ofSCOsource licensing revenue as a percentage of SCOsource licensing revenue was24 percent for the third quarter of fiscal year 2003 and 25 percent for firstthree quarters of fiscal year 2003. Cost of SCOsource licensing revenue includes the salaries and relatedpersonnel costs of internal personnel dedicated to the SCOsource licensinginitiative, as well as legal and professional fees incurred in connection withthe execution of the licensing agreements and the pursuit and defense of thelegal actions surrounding our intellectual property rights.  Cost of SCOsource licensing revenue mayfluctuate from quarter to quarter depending on the level of legal andprofessional expenses incurred with the enforcement of our intellectualproperty.  Additionally, we are unableto predict the percentage of cost of SCOsource licensing revenue for futurequarters due to the unpredictability of the related licensing revenue.

 

*Cost of ServicesRevenue.*  Cost of servicesrevenue was $1,538,000 for the third quarter of fiscal year 2003 and $2,494,000for the third quarter of fiscal year 2002, representing a decrease of $956,000,or 38 percent.  Cost of servicesrevenue as a percentage of services revenue was 78 percent for the thirdquarter of fiscal year 2003 and 91 percent for the third quarter of fiscal year2002.  Cost of services revenue was$5,008,000 for the first three quarters of fiscal year 2003 and $8,809,000 forthe first three quarters of fiscal year 2002, representing a decrease of$3,801,000, or 43 percent.  Costof services revenue as a percentage of services revenue was 78 percent for thefirst three quarters of fiscal year 2003 and 102 percent for the first threequarters of fiscal year 2002.

 

The decrease in cost ofservices revenue as a percentage of services revenue in fiscal year 2003compared to fiscal year 2002 was attributable to decreased employee and relatedcosts in our support services and professional services organization, decreasedcosts from external professional services providers and from the elimination ofcertain third party support contracts.

 

For the fourth quarter offiscal year 2003, we expect cost of services revenue as a percentage ofservices revenue to decline slightly from the third quarter of fiscal year 2003as we continue to implement cost reductions and generate other internalefficiencies.

 

### ***OperatingExpenses***

 

*Sales andMarketing.*  Sales and marketingexpenses were $5,930,000 for the third quarter of fiscal year 2003 and$6,908,000 for the third quarter of fiscal year 2002, representing a decreaseof $978,000, or 14 percent.  Sales andmarketing expenses represented 30 percent of total revenue for the thirdquarter of fiscal year 2003 down from 45 percent of total revenue for the thirdquarter of fiscal year 2002.  Sales andmarketing expenses were $18,421,000 for the first three quarters of fiscal year2003 and $22,944,000 for the first three quarters of fiscal year 2002, representinga decrease of $4,523,000, or 20 percent. Sales and marketing expenses represented 34 percent of total revenue forthe first three quarters of fiscal year 2003 as compared to 47 percent of totalrevenue for the first three quarters of fiscal year 2002.

 

The decrease in thedollar amount of sales and marketing expense in the third quarter and for thefirst three quarters of fiscal year 2003 compared to the third quarter and forthe first three quarters of fiscal year 2002 was attributable to fewer salesand marketing employees, reduced travel expenses, fewer commissions and lowerco-operative advertising costs as a result of lower revenue, and reducedcommunication costs.  We expect oursales and marketing

 

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expenses for the last quarter of fiscal year 2003 will decreaseslightly compared to the costs incurred in the third quarter of fiscal year2003.

 

*Research andDevelopment.*  Research anddevelopment expenses were $2,950,000 for the third quarter of fiscal year 2003and $4,284,000 for the third quarter of fiscal year 2002, representing adecrease of $1,334,000, or 31 percent. Research and development costs represented 15 percent of total revenuefor the third quarter of fiscal year 2003 as compared to 28 percent of totalrevenue for the third quarter of fiscal year 2002.  Research and development expenses were $8,142,000 for the firstthree quarters of fiscal year 2003 and $13,810,000 for the first three quartersof fiscal year 2002, representing a decrease of $5,668,000, or 41 percent.  Research and development costs represented15 percent of total revenue for the first three quarters of fiscal year 2003and 28 percent of total revenue for the first three quarters of fiscal year2002.

 

The decrease in the dollar amount ofresearch and development expenses in the third quarter and the first threequarters of fiscal year 2003 compared to the third quarter and the first threequarters of fiscal year 2002 was attributable to fewer employees, andreduced outside consulting and contract services.  These cost reductions were driven by consolidating developmentefforts on core engineering projects related to our UNIX operatingsystems.  For the last quarter of fiscalyear 2003, we anticipate that our research and development expenses willslightly increase compared to the costs incurred in the third quarter of fiscalyear 2003 as we will begin investing additional resources in our UNIX-basedoperating systems, OpenServer and UnixWare, and our web services initiative,SCOx.

 

*General andAdministrative.* General and administrative expenses were $1,413,000 for the thirdquarter of fiscal year 2003 and $2,260,000 for the third quarter of fiscal year2002, representing a decrease of $847,000, or 37 percent.  General and administrative expensesrepresented 7 percent of total revenue for the third quarter of fiscal year2003 and 15 percent of total revenue for the third quarter of fiscal year2002.  General and administrative expenseswere $4,525,000 for the first three quarters of fiscal year 2003 and $7,394,000for the first three quarters of fiscal year 2002, representing a decrease of$2,869,000, or 39 percent.  General andadministrative expenses represented 8 percent of total revenue for the firstthree quarters of fiscal year 2003 and 15 percent of total revenue for thefirst three quarters of fiscal year 2002.

 

The decrease in generaland administrative expenses in the third quarter and the first three quartersof fiscal year 2003 compared to the third quarter and the first three quartersof fiscal year 2002 was primarily attributable to fewer employees, and reducedcosts for external professional services. We expect general and administrative expenses for the last quarter offiscal year 2003 will remain consistent with the costs incurred in the thirdquarter of fiscal year 2003.

 

*Restructuring Charges. *During the third quarter of fiscal year 2003, werecorded a restructuring charge of $614,000. The restructuring charge for the third quarter of fiscal year 2003 wascomprised entirely of severance and related payments incurred from terminatingapproximately 35 employees.  During thethird quarter of fiscal year 2002, we recorded a restructuring charge of$1,245,000.  The restructuring chargefor the third quarter of fiscal year 2002 was comprised of termination paymentsmade to employees in connection with a reduction in headcount and theelimination of non-essential facilities totaling $2,800,000, offset by a$1,555,000 adjustment from a successful lease renegotiation on one of ourfacilities that had been vacated in connection with a previous corporaterestructuring.

 

During the first threequarters of fiscal year 2003, we recorded restructuring charges of $498,000,and for the first three quarters of fiscal year 2002, we recorded restructuringcharges of $5,581,000.  Therestructuring charges for the first three quarters of fiscal 2003 werecomprised primarily of severance payments to terminated employees andadjustments to previously recorded amounts and the restructuring charges forthe first three quarters of fiscal 2002 were

 

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comprised primarily of severance payments to terminated employees, theelimination of non-essential facilities, and an adjustment for a successfullease renegotiation.

 

*Amortization of Intangibles. *Werecorded $895,000 for the amortization of intangibles in the third quarter offiscal year 2003 and $701,000 in amortization during the third quarter offiscal year 2002.  We recorded $2,295,000for the amortization of intangibles for the first three quarters of fiscal year2003 and $2,152,000 in amortization during the first three quarters of fiscalyear 2002.  This amortization expense isfor intangible assets we acquired in connection with the acquisition oftechnology and other assets from third parties.  The increase in the amortization expense is the result of ouracquisition of certain assets from Vultus, Inc. during the three months endedJuly 31, 2003.

 

*Write-downof Investment. *During the third quarter and the first threequarters of fiscal year 2003, we did not have any write-down ofinvestments.  During the first three quarters of fiscalyear 2002, we determined that the current carrying value of our investment inLineo, Inc. would not be realized and a write-down was necessary.  We recorded a write-down of $1,180,000related to this investment.

 

*Stock-basedCompensation (Benefit). *Inconnection with stock options and restricted shares granted to employees andothers, we recorded stock-based compensation of $309,000 in the third quarterof fiscal year 2003 and a benefit of ($89,000) for the third quarter of fiscalyear 2002.  We recorded stock-basedcompensation of $927,000 for the first three quarters of fiscal year 2003 and$528,000 for the first three quarters of fiscal year 2002.

 

The increase instock-based compensation in the third quarter and first three quarters offiscal year 2003 is primarily attributable to restricted stock grants, wherebythe fair value of the restricted stock awards is recorded as a component ofstock-based compensation as the restrictions lapse.  We also issued a warrant to a consultant which increased ourstock-based compensation in the 2003 periods.

 

*Equity in Loss of Affiliate*

 

Theequity in loss of affiliate relates to our investment in Vista.com (“Vista”),which is accounted for under the equity method of accounting for investments.  Under theequity method, we recognize our portion of the net income or net loss of Vistain our consolidated statements of operations. During the third quarter of fiscal year 2003, we recognized a loss of$71,000 that represented our portion of Vista’s net loss.  For the first three quarters of fiscal year2003, we recognized a loss of $171,000 that represented our portion of Vista’snet loss.  We did not have an investmentin Vista during the comparable fiscal year 2002 periods.

 

### ***Other Income(Expense), net***

### ** **

Other income (expense), net, which consistsprincipally of interest expense, interest income and other income, was a netexpense of $55,000 for the third quarter of fiscal year 2003 and for the thirdquarter of fiscal year 2002, and a net expense of $59,000 for the first threequarters of fiscal year 2003 and $120,000 for the first three quarters offiscal year 2002.

 

### ***Provision forIncome Taxes***

 

Theprovision for income taxes was $188,000 for the third quarter of fiscal year2003 and $214,000 for the third quarter of fiscal year 2002.  The provision for income taxes was $495,000for the first three quarters of fiscal year 2003 and $431,000 for the firstthree quarters of fiscal year 2002.  Theprovision for the third quarter of fiscal year 2003 related entirely toearnings of our foreign subsidiaries. The provision for income taxes for the first three quarters of fiscalyear 2003

 

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was primarily related to earnings offoreign subsidiaries as well as federal alternative minimum tax in the U.S. andstate income taxes for states in which we do not have sufficient net operatingloss carry forwards to offset current earnings.  Our U.S. federal income tax provision for the first threequarters of fiscal year 2003 has been offset with the utilization of netoperating loss carry forwards.

 

LIQUIDITY AND CAPITALRESOURCES

 

Since inception, we havefunded our operations primarily through loans from our major stockholder andthrough sales of common and preferred stock. During the nine months ended July 31, 2003, our operations producedpositive cash flow.  We believe that wewill have sufficient financial resources to fund our current operations for atleast the next twelve months, however, if our cash reserves, cash fromoperations and existing unused line of credit are insufficient to meet ourneeds, we may not be able to execute our business plan and our operations maybe adversely impacted.

 

As of July 31, 2003,we had cash and cash equivalents of $14,661,000 and working capital of$6,007,000, which includes current liabilities of $6,822,000 for deferredrevenue that will not require dollar for dollar of cash to settle, but will berecognized as revenue in future periods. Our total cash and cash equivalents has increased by $8,072,000 fromOctober 31, 2002.  This increaseresulted primarily from cash provided by SCOsource licensing revenue.  Additionally, we have a $2,910,000 line ofcredit with a commercial bank that bears interest at the prime rate minus onepercent (with a floor rate of 3.75 percent) that matures on October 31,2003.  Borrowings under the line ofcredit are secured by a letter of credit from our principal stockholder.  As of July 31, 2003, there were noborrowings outstanding under the line of credit.

 

Ournet cash provided by operations during the nine months ended July 31, 2003was $7,442,000.  Cash provided byoperations was primarily attributable to net income of $6,872,000.  Non-cash expenses totaled $4,555,000 andcash used by changes in operating assets and liabilities was $3,985,000.  Our working capital position increased froma deficit of $6,332,000 as of October 31, 2002 to a positive $6,007,000 asof July 31, 2003, and our long-term liabilities have decreased from$1,625,000 to $611,000 during that same period.

 

Ourinvesting activities have historically consisted of equipment purchases,investing in strategic partners and the purchase and sale of available-for-salesecurities.  During the nine monthsended July 31, 2003, cash used in investing activities was $2,140,000,which was primarily a result of equipment purchases of $524,000, our investmentin affiliated entities of $950,000 and cash paid to wind down our UnitedKingdom subsidiary of $666,000.

 

Our financingactivities provided $2,329,000 during the nine months ended July 31, 2003and consisted of proceeds received from the exercise of stock options of$1,443,000, proceeds from the purchase of shares of common stock by ouremployees through our employee stock purchase program of $236,000 and proceedsfrom the issuance of warrants of $650,000.

 

Our net accounts receivable balance decreased from $8,622,000as of October 31, 2002 to $7,398,000 as of July 31, 2003.  The allowance for doubtful accounts was$138,000 as of July 31, 2003, which represented approximately 2 percent ofour gross accounts receivable balance. Our write-offs of uncollectible accounts have not been significant.

 

On June 6, 2003, we acquired substantially allthe assets of Vultus, Inc. (“Vultus”), a corporation engaged in the webservices interface business.  We issued305,274 shares of our restricted common stock and assumed liabilities ofapproximately $215,000 in connection with this acquisition.  We extended employment offers to most of theVultus employees, and as a result, will have increased research and developmentcosts in future periods.

 

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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 2008.  In recent corporate restructuringactivities, we have partially vacated some of these facilities, but still havecontractual obligations to continue to make ongoing lease payments that willuse available cash.  We have pursued andwill continue to pursue sublease opportunities, as available, to minimize thisuse of cash; however, we can not assure that we will be successful ineliminating or reducing cash expenditures for these leases.

 

The following tablesummarizes our contractual lease obligations as of July 31, 2003 (inthousands):  

 
|                |   | **Operating  Leases** |   |
|---------------------|--------|-----------------------|--------|
|                |   |                  |   |
| Less than one year  |   | $                     | 1,197  |   |
| One to three years  |   | 5,084                 |   |
| Three or more years |   | 845                   |   |
| Total payments      |   | $                     | 7,126  |   |

 

We do not engage in any off balance sheet financingarrangements.

 

CRITICAL ACCOUNTING POLICIES

 

Our critical accounting policies and estimatesinclude the following:

 

•                              Revenuerecognition;

 

•                              Incometaxes and related valuation allowances;

 

•                              Impairmentof long-lived assets; and

 

•                              Allowancesfor doubtful accounts and product returns.

 

In each of these areas, management makes estimatesbased on historical results, current trends and future projections.

 

*Revenue Recognition*

 

We recognize revenue in accordance with Statement ofAccounting Position (“SOP”) 97-2, as amended, and Staff Accounting Bulletin(“SAB”) 101.  Revenue recognition inaccordance with these pronouncements can be complex due to the nature andvariability of our sales transactions. We recognize product revenue upon shipment if a signed contract exists,the fee 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.  For contracts involvingmultiple elements (i.e. delivered and undelivered products, maintenance andother services), we allocate revenue to each component of the contract based onobjective evidence of its fair value, which is specific to us.  The fair value of each element is based onamounts charged when such elements are sold separately.  We recognize revenue allocated toundelivered products when the criteria for revenue recognition set forth abovehave been met.

 

Our SCOsource licensing revenue to date has beengenerated from license agreements that are non-exclusive, perpetual, paid uplicenses to utilize our UNIX source code. We recognize revenue from licensing agreements when a signed contractexists, the fee is fixed and determinable, collection of the receivable isprobable and delivery has occurred.  Ifthe payment

 

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terms extend beyond ournormal payment terms, revenue is recognized as the payments become due.

 

We recognize revenue from maintenance fees for ongoingcustomer support and product updates ratably over the period of the maintenancecontract.  Payments for maintenance feesare generally made in advance and are non-refundable.  For revenue allocated to education and consulting services orderived from the separate sale of such services, we recognize revenue as therelated services are performed.  Werecognize product revenue from royalty payments upon receipt of quarterlyroyalty reports from OEMs related to their product sales.

 

*Income Taxes and Related Valuation Allowance*

 

We have provided a valuation allowance of $48,644,000against our entire net deferred tax asset as of October 31, 2002.  The valuation allowance was recorded becauseof our history of net operating losses and the uncertainties regarding ourfuture operating profitability and taxable income.  Had different assumptions been used regarding the valuationallowance and our net deferred tax asset, our income tax provision could havebeen materially different than that reported.

 

*Impairment of Long-lived Assets*

 

We review our long-lived assets for impairment whenevents or changes in circumstances indicate that the book value of an asset maynot be recoverable.  We evaluate, ateach balance sheet date, whether events and circumstances have occurred whichindicate possible impairment.  Thecarrying value of a long-lived asset is considered impaired when theanticipated cumulative undiscounted cash flows of the related asset or group ofassets is less than the carrying value. In that event, a loss is recognized based on the amount by which thecarrying value exceeds the estimated fair market value of the long-lived asset.

 

We performed a valuation of our intangible assets asof October 31, 2002 in accordance with SFAS No. 142, “Goodwill and OtherIntangible Assets” and determined that the intangible assets reported in theaccompanying consolidated balance sheets are not impaired.  Write-downs of intangible assets may benecessary if the future fair value of these assets is less than carrying value.

 

*Allowance for Doubtful Accounts and Product Returns*

 

We offer credit terms on thesale of our products to a significant majority of our customers and require nocollateral from these customers.  Weperform ongoing credit evaluations of our customers’ financial condition andmaintain an allowance for doubtful accounts receivable based upon ourhistorical collection experience and expected collectibility of all accountsreceivable.  We also maintain anallowance for estimated returns based on our historical experience.  Our actual bad debts and returns may differfrom our estimates and the differences may be material.

 

RECENTACCOUNTING PRONOUNCEMENTS

 

In November 2002,the FASB issued Interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness toOthers”*,*an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASBInterpretation No. 34.  ThisInterpretation elaborates on the disclosures to be made by a guarantor in itsinterim and annual financial statements about its obligations under guaranteesissued.  The Interpretation alsoclarifies that a guarantor is required to recognize, at inception of aguarantee, a liability for the fair value of the obligation undertaken.  The initial recognition and measurementprovisions of the Interpretation are applicable to guarantees issued ormodified after December

 

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31, 2002 and are not expected to have a material effect on theCompany’s financial statements.  Thedisclosure requirements are effective for financial statements of interim orannual periods ending after December 15, 2002.

 

In December 2002,the FASB issued SFAS No. 148*,*“Accounting for Stock-Based Compensation– Transition and Disclosure”, an amendment of FASB Statement No. 123.  This Statement amends FASB Statement No.123, “Accounting for Stock-Based Compensation”*,* to provide alternativemethods of transition for a voluntary change to the fair value method ofaccounting for stock-based employee compensation.  In addition, SFAS No. 148 amends the disclosure requirements ofSFAS No. 123 to require prominent disclosures in both annual and interimfinancial statements.  Certain of thedisclosure modifications are required for fiscal years ending after December 15,2002.

 

In January 2003, theFASB issued Interpretation No. 46, “Consolidation of Variable InterestEntities, an Interpretation of ARB No. 51”*.* This Interpretation addresses the consolidation by business enterprisesof variable interest entities created after January 31, 2003 and tovariable interests in variable interest entities obtains after January 31,2003.  The application of thisInterpretation is not expected to have a material effect on the Company’sfinancial statements.  The Interpretationrequires certain disclosures in financial statements issued afterJanuary 31, 2003 if it is reasonably possible that the Company willconsolidate or disclose information about variable interest entities when theInterpretation becomes effective.

 

In May 2003, theFASB issued SFAS No. 150, “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity”. * *SFAS No. 150 establishes standards for how anissuer classifies and measures certain financial instruments with characteristicsof both liabilities and equity. Financial instruments within the scope of SFAS No. 150 will beclassified as liabilities and measured at fair value.  Many of those instruments were previously classified asequity.  The statement is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise effective at the beginning of the first interim period beginningafter June 15, 2003.  The adoptionof SFAS No. 150 is not expected to have an impact on our financial position orresults of operations.

 
| ITEM 3. | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
|---------|-------------------------------------------------------------|

 

The stock market in generaland the market for shares of technology companies in particular, hasexperienced extreme price fluctuations. In addition, factors such as new product introductions by ourcompetitors and us and public perception about the strength of our intellectualproperty claims may have a significant impact on the market price of our commonstock.  These conditions could cause theprice of our stock to fluctuate substantially over short periods of time.

 

FOREIGN CURRENCY RISK

 

We have foreign offices andoperations primarily in Europe and Asia. As a result, a substantial portion of our revenue is derived from salesto customers outside the United States. Most of this international revenue is denominated in U.S. dollars.  However, most of the operating expensesrelated to the foreign-based operations are denominated in foreign currenciesand therefore operating results are affected by changes in the U.S. dollarexchange rate in relation to foreign currencies such as the Euro, amongothers.  If the U.S. dollar weakenscompared to the Euro, our operating expenses for foreign operations will behigher when translated back into U.S. dollars and additional funds may berequired to meet these obligations.  Ourrevenue can also be affected by general economic conditions in the UnitedStates, Europe and other international markets.  Our results of operations may be affected in the short term byfluctuations in foreign currency exchange rates.

 

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The Company utilizes foreign currency forward exchangecontracts to hedge foreign currency market exposures of underlying assets andliabilities.  We do not use forwardexchange contracts for speculative or trading purposes.  Our accounting policies for theseinstruments are based on our designation of such instruments as hedgingtransactions.  The criteria we use fordesignating an instrument as a hedge include the instrument’s effectiveness inrisk reduction and one-to-one matching of forward exchange contracts tounderlying 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 July 31, 2003, we had two foreign exchange contracts with amaturity of 30 days to sell an aggregate of 243,000 Euro and 689,000 UnitedKingdom pounds for $1,334,000 U.S. dollars.

 

INTEREST RATE RISK

 

The primary objective ofour cash management strategy is to invest available funds in a manner that assuresmaximum safety and liquidity and maximizes yield within such constraints.  We do not borrow money for short-terminvestment purposes.

 

INVESTMENT RISK

 

We have invested in equityinstruments of privately held and public companies in the high-technologyindustry for 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 July 31,2003, our investments balance was approximately $774,000.

 
| ITEM 4. | CONTROLS  AND PROCEDURES |
|---------|--------------------------|

 

(a)                                  Evaluation of Disclosure Controls andProcedures

 

Under the supervision andwith the participation of our management including our Chief Executive Officerand Chief Financial Officer, we evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rules13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934 (the “ExchangeAct”)) as of July 31, 2003.  Basedupon that evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that, as of the end of the period covered by this report, ourdisclosure controls and procedures were effective in timely alerting them tothe material information relating to us (or our consolidated subsidiaries)required to be included in the reports we file or submit under the ExchangeAct.

 

(b)                                 Changes in Internal Controls

 

During the most recentfiscal quarter covered by this report, there has been no change in our internalcontrols over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f)under the Exchange Act) that has materially affected, or reasonably likely tomaterially affect our internal control over financial reporting.

 

#### ***FORWARD-LOOKING STATEMENTS***

 

#### ***With the exception of historical facts, the statementscontained in Management’s Discussion and Analysis of Financial Condition andResults of Operations are “forward-looking***

 

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statements” within the meaning of the Private Securities LitigationReform Act of 1995 (the “Reform Act”) which reflect our current expectationsand beliefs regarding our future results of operations, performance andachievements.  These statements aresubject to risks and uncertainties and are based upon assumptions and beliefsthat may or may not materialize.  Theseforward-looking statements include, but are not limited to, statementsconcerning:

#### *** ***

•                              Ourexpectation and our ability to enter into future license agreements withdevelopers, manufacturers, distributors and end-users of operating systems inour SCOsource effort or to predict the amount or timing of revenue from suchagreements in future periods;

 

•                              Thestrength of our intellectual property rights and contractual claims regardingUNIX generally and specifically the strength of our claim that unauthorizedUNIX source code and derivatives of UNIX source code are prevalent in Linux;

 

•                              Our intentions to continue to investin our core UNIX operating system products (OpenServer and UnixWare) and ourbelief that a significant portion of our product revenue in upcoming quarterswill come from such products;

 

•                              Our expectation that in the fourthquarter of fiscal year 2003 our cost of products revenue as a percentage ofproducts revenue will be consistent with the third quarter of fiscal 2003;

 

•                              Ourexpectation that in the fourth quarter of fiscal year 2003 our cost of servicesas a percentage of services revenue will decline slightly from the thirdquarter of fiscal year 2003;

 

•                              Our beliefthat in the fourth quarter of fiscal year 2003 our sales and marketing expenseswill decrease slightly compared to our expenses incurred in the third quarterof fiscal year 2003;

 

•                              Our beliefthat in the fourth quarter of fiscal year 2003 our research and developmentexpenses will slightly increase compared to our expenses incurred in the thirdquarter of fiscal year 2003;

 

•                              Ourexpectation that in the fourth quarter of fiscal year 2003 our general andadministrative expenses will remain consistent with our costs incurred in thethird quarter of fiscal year 2003; and

 

•                              Our beliefthat we will have sufficient financial resources to fund operations for thenext 12 months. 

 

We wish to caution readers that our operating resultsare subject to various risks and uncertainties that could cause our actualresults and outcomes to differ materially from those discussed or anticipated,including the risk factors set forth below in the section entitled “RiskFactors.”  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.

 

**Risk Factors**

 

*We donot have a history of profitable operations.*

 

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The July 31, 2003, quarter was our secondconsecutive quarter of profitability as a result of our SCOsource licensingrevenue.  If we do not receive SCOsourcelicensing revenue in future quarters and our revenue from the sale of ouroperating system platform products and services continues to decline, we willneed to further reduce operating expenses to maintain profitability or generatepositive cash flow.  In our quarterlyresults of operations, we recognize revenue from agreements for support andmaintenance contracts and other long-term contracts that have been previouslyinvoiced and are included in deferred revenue. Our deferred revenue balance has declined from October 31, 2002 toJuly 31, 2003, and this decline in deferred revenue may continue intofuture quarters, which may have a negative impact on our operating systemplatform products revenue.  Our futureoperating system platform revenue may be adversely impacted and may continue todecline if we are unable to replenish these deferred revenue balances withlong-term maintenance and support contracts or replace them with othersustainable revenue streams.  If we areunable to continue to generate positive cash flow and profitable operations,our operations may be adversely impacted.

 

*Ourfuture SCOsource licensing revenue is uncertain.*

 

We initiated the SCOsource licensing effort inJanuary 2003 to review the status of UNIX licensing and sublicensingagreements and to identify others in the industry that may be currently usingour intellectual property without obtaining the necessary licenses.  This effort resulted in the execution of twolicense agreements during the quarter ended April 30, 2003, quarter, andthe receipt of additional license fees from these two contracts during theJuly 31, 2003 quarter.  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 SCOsourceinitiative is unlikely to produce stable, predictable revenue for theforeseeable future, and the success of this initiative in some part may dependon the perceived strength of our intellectual property rights and contractualclaims regarding UNIX, including, the strength of our claim that unauthorizedUNIX System V source code and derivatives are prevalent in Linux.

 

*Our stock price is volatile.*

 

The trading price for our common stock has beenvolatile, ranging from a low closing sales price of $1.09 inmid-February 2003, to recent highs near $18.00 per share.  The share price has changed dramaticallyover short periods with increases and decreases of over 25 percent in a singleday.  We believe that the changes in ourstock price are affected by changing public perceptions concerning the strengthof our intellectual property claims and other factors beyond our control.  Public perception can change quickly andwithout any change or development in our underlying business or litigationposition.  An investment in our stock issubject to such volatility and, consequently, is subject to significant risk.

 

*Ourcompetitive position could decline if we are unable to obtain additionalfinancing.*

 

We may need to raise additional funds to expand ourbusiness, support operations, fund litigation expenses, respond to competitivepressures, acquire complementary businesses or technologies or respond tounanticipated requirements.  We cannotassure that additional funding will be available to us in amounts or on termsacceptable to us.

 

*Unintendedconsequences of our assertion of intellectual property may adversely affect ourbusiness*.

 

On or aboutMarch 6, 2003, we filed acomplaint against IBM alleging breach of contract, misappropriation of tradesecrets, tortious interference, and unfair competition.  The complaint centers on IBM’s activitiesregarding the UNIX operating system that underlies our UNIX-based

 

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operating systems and IBM’s AIX UNIX-based operatingsystem.  The complaint alleges that IBMobtained information concerning the UNIX source code from us andinappropriately used and distributed that information in connection with itsefforts to promote the Linux operating system.

 

On or about June 16,2003, we filed an amended complaint in the IBM case.  The amended complaint essentially restates and realleges 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 which IBM acquired.  We allege that IBM breached the Sequentagreement in several ways similar to those set forth above and we are seekingdamages flowing from those breaches.  Weare also seeking injunctive relief on several of our claims.

 

IBM has filed aresponse and counter claim to the complaint, including a demand for jurytrial.  The discovery process of theaction has just commenced.  The actionhas been removed from Utah Third District State Court and is currently pendingin the Federal District Court for the District of Utah.

 

In its counter claim, IBM asserts that we do not havethe right to terminate its UNIX license or assert claims based on our ownershipof UNIX intellectual property against them or others in the Linuxcommunity.  In addition, they assertthat we have infringed on certain patents held by IBM.  Their counter claims include claims forbreach of contract, violation of the Lanham Act, unfair competition,intentional interference with prospective economic relations, unfair anddeceptive trade practices, breach of the GNU general public license, and patentinfringement.  We intend to vigorouslydefend this action.

 

In addition, wehave publicly, and in individual letters to 1,500 of the world’s largestcorporations, cautioned users of Linux that there are unresolved intellectualproperty issues surrounding Linux that may expose them to unanticipatedliability.  As a result of theseconcerns, we have suspended our sales of Linux products.

 

If we do notprevail in our action against IBM, or if IBM is successful in its counter claimagainst us, our business and results of operations could be materiallyharmed.  The litigation with IBM andothers could be costly, and our costs for legal fees may be substantial and inexcess of amounts we have budgeted for. In addition, we may experience a decrease in revenue as a result of theloss of sales of Linux products and initiatives previously undertaken jointlywith IBM and others affiliated with IBM or sympathetic to the Linuxmovement.  We are informed thatparticipants in the Linux industry have attempted to influence participants inthe markets in which we sell our products to reduce or eliminate the amount ofour products and services that they purchase. They have been somewhat successful in those efforts and will likelycontinue.  There is also a risk that theassertion of our intellectual property rights will be negatively viewed byparticipants in our marketplace and we may lose support from suchparticipants.  Any of the foregoing couldadversely affect our position in the marketplace and our results of operations.

 

As a result of our assertion of our intellectualproperty rights, we have been subjected to several denial of service attacks onour website which prevented web users from accessing our website and doingbusiness with us for a period of time.  If such attacks continue orif our customers and strategic partners are also subjected to similar attacks,our business and results of operations could be materially harmed.

 

*Our assertions surrounding our UNIX intellectual propertymay subject us to additional legal proceedings.*

 

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On or about August 4, 2003, Red Hat filed acomplaint against us that is currently pending in the United States DistrictCourt for the District of Delaware.  RedHat has asserted that the Linux operating system does not infringe on our UNIXintellectual property rights and seeks a declaratory judgment for non-infringementof copyrights and no misappropriation of trade secrets.  In addition, Red Hat claims we have engagedin false advertising in violation of the Lanham Act, deceptive trade practices,unfair competition, tortious interference with prospective business opportunities,and trade libel and disparagement.  RedHat also announced it was contributing $1 million to establish the Open SourceNow fund to help pay the costs of Linux companies involved in legal action,with us and encouraged other participants in the Linux community to makecontributions.  If Red Hat is successfulin its claim against us, our business and results of operations could bematerially harmed.

 

The Australian Competition and Consumer Commission(the “ACCC”) has contacted us regarding complaints it has received regardingour intellectual property claims and our statements regarding the need forcommercial Linux users to obtain a UNIX license.  We intend to respond tothe ACCC’s inquiry.  The ACCC has notified us that it has not made anydecision to pursue the complaints it has received or determined what, if any,action it will take.

 

Several entities in Germany have obtained temporaryrestraining orders in Germany precluding our German subsidiary, from makingstatements in Germany that, in substance, disparage Linux, or entities involvedin the Linux industry, or implicate Linux as infringing our intellectualproperty rights.  SCO GmbH has received an administrative fine of 10,000Euro for a technical violation of one of the temporary restrainingorders.  We are currently negotiating with the various claimants inGermany over the temporary restraining orders and are evaluating whether wewill appeal the administrative fine.  Informal complaints similar to thoseraised in Germany have been received from companies in Austria and Poland.  We have responded to those complaints.  It is not known if those complainants willtake future action.

 

In addition to these above-mentioned actions, otherregulators or others in the Linux community may initiate legal actions againstus, all of which may negatively impact our operations or future operatingperformance.

 

*If our SCO* b*randing effort is not accepted or causes market confusion, our businessmay be adversely affected.*

 

We recently launched a rebranding effort for ourproducts and services as well as our corporate image.  On May 16, 2003, our stockholders approved the change of ourcorporate name to The SCO Group, Inc. Prior to our name change, we renamed our UNIX products and servicesusing the SCO trademark to draw on this strong brand recognition.  We acquired the rights to use this trademarkin May 2001 from Tarantella in connection with our acquisition of certainTarantella assets and operations.  Ifthe rebranding effort is not accepted by our resellers or customers of ourproducts and services, if the rebranding efforts cause confusion, or if thereare negative connotations associated with the trademark that we cannotsuccessfully address, our business may be adversely affected.

 

*If our recently launched products and services are not acceptedin the marketplace, our business may be adversely affected.*

 

In January 2003, we announced SCOsource, ourintellectual property licensing business and in April 2003 announced SCOx,our web services strategy.  In addition,we have recently released new versions of our SCO OpenServer and SCO UnixWareoperating systems.  If our resellers orcustomers do not accept these initiatives or product enhancements, if theproducts fail to perform as expected, or if revenue from these initiatives isbelow our expectations, our business may be adversely affected.

 

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

 

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

 

Factors that may affectour quarterly results include:

 

•                  our ability to successfully negotiateand complete licensing and other agreements related to our intellectualproperty;

 

•                  the interest level of resellers inrecommending our UNIX business solutions to end users;

 

•                  the introduction, development,timing, competitive pricing and market acceptance of our products and servicesand those of our competitors;

 

•                  changes in general economicconditions, such as recessions, that could affect capital expenditures andrecruiting efforts in the software industry;

 

•                  changes to, or developments, in ouron-going litigation with IBM and Red Hat concerning our UNIX intellectualproperty;

 

•                  changes in business attitudes towardUNIX as a viable operating system compared to other competing systems; and

 

•                  changes in attitudes of customers dueto our aggressive position against the inclusion of our UNIX code in Linux.

 

We also experience fluctuations in operating resultsin interim periods in Europe and the Asia Pacific regions due to seasonalslowdowns and economic conditions in these areas.  Seasonal slowdowns in these regions typically occur during thesummer months.

 

As a result of the factors listed above and elsewhere,it is possible that our results of operations may be below the expectations ofpublic market analysts and investors in any particular period.  This could cause our stock price todecline.  If revenue falls below ourexpectations and we are unable to quickly reduce our spending in response, ouroperating results will be lower than expected. Our stock price may fall in response to these events.

 

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

 

We have a two-tiereddistribution channel.  The relationshipswe have developed with resellers allow us to offer our products and services toa much larger customer base than we would otherwise be able to reach throughour own direct sales and marketing efforts. Some electronic solution providers also purchase solutions through ourresellers, and we anticipate they will continue to do so as we expand ourproduct offerings.  Because we usuallysell indirectly through resellers, we cannot control the relationships throughwhich solution providers or equipment integrators purchase our products.  In turn, we do not control the presentationof our products to end-users. Therefore, our sales could be affected by disruptions in therelationships between us and our resellers, between our resellers andelectronic solution providers, or between electronic solution providers and endusers.  Also, resellers and electronicsolution providers may

 

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choose not to emphasize our products to their customers.  Any of these occurrences could diminish theeffectiveness of our distribution channel and lead to decreased sales.

 

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

 

Our revenue from the saleof UNIX-based products has declined over the last eight quarters.  This decrease in revenue has beenattributable to the worldwide economic slowdown, lower information technologyspending, and increased competitive pressures from alternative operatingsystems.  If the demand for UNIX-basedproducts continues to decline, and we are unable to develop new products andservices that successfully address a market demand, our business will beadversely affected.

 

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

 

Inthe UNIX operating system market, our competitors include IBM, Microsoft,Hewlett Packard and Sun.  These andother competitors are aggressively pursuing the current UNIX operating systemmarket.  Many of thesecompetitors have access to greater resources that we do.  More recently, the major competitivealternative to our UNIX products is Microsoft’s NT and Linux.  While we believe that our server productsretain a competitive advantage in a number of targeted application areas, theexpansion of Microsoft’s and our other competitors’ offerings may restrict theoverall market available for our server products, including some markets wherewe have been successful in the past.

 

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

 

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

 

•                  potential loss of developedtechnology through piracy, misappropriation, or more lenient laws regardingintellectual property protection;

 

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

 

•                  fluctuations in currency exchangerates and economic instability;

 

•                  longer payment cycles for sales inforeign countries;

 

•                  seasonal reductions in businessactivity; and

 

•                  political unrest, particularly inareas where we have facilities.

 

In addition, certain ofour operating expenses are denominated in local currencies, creating risk offoreign currency translation losses that could harm our financial results andcash flows.  When we generate profits inforeign countries, our effective income tax rate is increased, even though wegenerate consolidated net losses.

 

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

 

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

 

During the last severalquarters the U.S. and European economies have experienced an economic slowdownthat has affected the purchasing habits of many consumers across many industriesand across many geographies.  This hascaused the delay, or even cancellation of technology purchases.  The ultimate impact of the slowdown in theUnited States and Europe is difficult to predict, but it has resulted indecreased sales of our products, longer sales cycles and lower prices.  If the current slowdown continues, ourrevenue and results of operations may continue to be lower than expected.  In addition, the slowdown may also affectthe end-user market making it more difficult for our reseller channel to sellour products.

 

*Futuresales of our common stock may negatively affect our stock price.*

 

Certainholders of our common stock have demand and piggyback registration rightsobligating us to register their shares under the Securities Act for sale.  The market price of our common stock coulddecline as a result of sales of a large number of shares of our common stock inthe market, or the perception that such sales could occur.  This also might make it more difficult forus to sell equity securities in the future at a time and at a price that wedeem appropriate.

 

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

 

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

 

PARTII.                                                 OTHERINFORMATION

 

ITEM 1.                                   LEGALPROCEEDINGS

 

*IBM*

 

On or about March 6,2003, we filed a complaint against IBM. This action is currently pending in the United States District Court forthe District of Utah, under the title *CalderaSystems, Inc. d/b/a The SCO Group vs. International Business MachinesCorporation*, Civil No. 2:03CV0294. The complaint includes claims for breach of contract, misappropriationof trade secrets, tortious interference, and unfair competition.  The complaint alleges that IBM madeconcerted efforts to improperly destroy the economic value of UNIX, particularlyUNIX as used on Intel microprocessors, to benefit IBM’s Linux servicesbusiness.  As a result of IBM’s breachof contract and unfair competition and the marketplace injury sustained by SCO,we are requesting damages in an amount to be proven at trial, but no less than$1 billion, together with additional damages through and after the time oftrial.

 

On or about June 16,2003, we filed an amended complaint in the IBM case.  The amended complaint essentially restates and realleges theallegations of the original complaint and expands on those claims in severalways.  Most importantly, the amendedcomplaint raises new allegations regarding IBM actions and breaches through theproducts and services of Sequent Computer Systems, Inc. (“Sequent”) which IBMacquired.  We allege that IBM breached the

 

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Sequent agreement in several ways similar to those set forth above andit seeks damages flowing from those breaches. We are also seeking injunctive relief on several of its claims.

 

IBM has filed aresponse and counter claim to the complaint, including a demand for a jurytrial.  The discovery process of theaction has just commenced.  The actionhas been removed from Utah Third District State Court and is currently pendingin the Federal District Court for the District of Utah.

 

In its counter claim, IBM asserts that we do not havethe right to terminate its UNIX license or assert claims based on our ownershipof UNIX intellectual property against them or others in the Linuxcommunity.  In addition, they assertthat we have infringed on certain patents held by IBM.  Their counter claims include claims forbreach of contract, violation of the Lanham Act, unfair competition,intentional interference with prospective economic relations, unfair and deceptivetrade practices, breach of the GNU general public license, and patentinfringement.  We intend to vigorouslydefend this action.

 

*Red Hat*

 

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

 

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

 

*IPO Class Action Matter*

 

We are an issuer defendant in a series of class actionlawsuits filed in the United States District Court for the Southern District ofNew York, involving over 300 issuers that have been consolidated under *In re Initial Public Offering Securities Litigation*,21 MC 92 (SAS).  The plaintiffs, theissuers and the insurance companies have negotiated a Memorandum ofUnderstanding (“MOU”) with the intent of settling the dispute between theplaintiffs and the issuers.  We haveexecuted this MOU and have been advised that almost all (if not all) of theissuers have elected to proceed under the MOU. The MOU is still subject to court approval and the preparation ofappropriate settlement documents.  Ifthe settlement is approved by the court and settlement agreements can beentered into by the parties, and if no cross-claims, counter claims or thirdparty claims are later asserted, this action will be dismissed with respect tothe Company and its individuals.

 

*Other Matters*

 

The Australian Competition and Consumer Commission(the “ACCC”) has contacted us regarding complaints it has received regardingour intellectual property claims and our statements regarding the need forcommercial Linux users to obtain a UNIX license.  We intend to respond tothe ACCC’s inquiry.  The ACCC has notified us that it has not made anydecision to pursue the complaints it has received or determined what, if any,action it will take.

 

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Several entities in Germany have obtained temporaryrestraining orders in Germany precluding our German subsidiary, from makingstatements in Germany that, in substance, disparage Linux, or entities involvedin the Linux industry, or implicate Linux as infringing our intellectualproperty rights.  SCO GmbH has received an administrative fine of Euro10,000 for a technical violation of one of the temporary restrainingorders.  We are currently negotiating with various claimants in Germany overthe temporary restraining orders and are evaluating whether we will appeal theadministrative fine.  Informal complaints similar to those raised inGermany have been received from a company in Austria and Poland.  We have responded to those complaints.  It’s not known if those complainants willtake future action.

 

ITEM 2. CHANGES INSECURITIES AND USE OF PROCEEDS

 

In connection the acquisition of assets from Vultus,the Company issued shares of its common stock to Vultus and its sixshareholders in reliance on the exemption from registration provided by 4(2) ofthe Securities Act and the safe harbor of Regulation D promulgated thereunder.  Each of the Vultus shareholdershad held an equity interest in Vultus for some time and was familiar with thebusiness of Vultus prior to the transaction. In connection with the shareholder approval necessary for thetransaction, each Vultus shareholder was provided with an information statementprepared by Vultus that contained a summary of the proposed transaction, theanticipated distribution to each shareholder, a description of the restrictednature of the securities to be received and an information packet concerningthe Company.

 

During the quarter ended July 31, 2003, we issueda warrant to Sun in connection with us receiving the first of two payments of$2,500,000, required under the initial agreement.  The warrant allows Sun to acquire 12,500 shares of the Company’scommon stock at an exercise price of $1.83 per share for a term of five yearsfrom the date of the agreement.  Becausethe warrant was issued in connection with the advance payment, the Company hasrecorded the fair value of the warrant of $150,000, as determined using theBlack-Scholes option-pricing model, and reduced license revenueaccordingly.  Assumptions used in theBlack-Scholes option-pricing model to estimate its fair value were thefollowing: market value of common stock of $12.52 per share; risk-free interestrate of two percent; expected dividend yield of 0 percent; volatility of 137percent; and a term of five years.

 

In addition, weissued a warrant to a consultant, as part of an agreement to assist us with ourSCOsource licensing initiative.  Thewarrant allows the consultant to acquire 25,000 shares of our common stock atan exercise price of $8.50 per share for a term of two years from the date ofthe agreement.  We have recorded thefair value of the warrant of $94,000, as determined using the Black-Scholesoption-pricing model, as a warrant outstanding and included this cost as a costof licensing revenue.  Assumptions usedin the Black-Scholes option-pricing model to estimate the fair value were thefollowing: market value of common stock of $12.84 per share; risk-free interestrate of two percent; expected dividend yield of 0 percent; volatility of 143percent; and a term of 2 years.

 

Both of thesewarrants were issued pursuant to an exemption from the registrationrequirements under Section 4(2) of the Securities Act of 1933, as amended.

 

ITEM 4.                                   SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

 

The following matterswere submitted and approved by our stockholders at our annual meeting heldMay 16, 2003:

 

1.                                       Toelect seven members to the Board of Directors to serve until their successorshave been appointed. All seven directors were elected with Ralph J. Yarro IIIreceiving 10,405,000 votes in favor and 49,000 votes withheld, Thomas P.Raimondi, Jr. receiving 10,408,000

 

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votes in favor and 46,000 votes withheld; Edward E.Iacobucci receiving 10,421,000 votes in favor and 33,000 votes withheld; StevenM. Cakebread receiving 10,420,000 votes in favor and 34,000 votes withheld; R.Duff Thompson receiving 10,409,000 votes in favor and 45,000 votes withheld;Darcy G. Mott receiving 10,415,000 votes in favor and 39,000 votes withheld;and Darl C. McBride receiving 10,405,000 votes in favor and 49,000 voteswithheld.

 

2.                                       Toapprove an amendment to the 2002 Omnibus Stock Incentive Plan to provide for upto 1,500,000 shares of common stock to be subject to awards issued under theplan.  This resolution was passed with6,851,000 votes in favor, 196,000 votes against and 4,000 abstentions.

 

3.                                       Toapprove an amendment to the 2000 Employee Stock Purchase Plan to provide for anadditional 500,000 shares to be subject to awards issued under the plan.  This resolution was passed with 6,877,000votes in favor, 169,000 votes against and 4,000 abstentions.

 

4.                                       Toapprove an amendment to the Certificate of Incorporation to change our namefrom Caldera International, Inc. to The SCO Group, Inc.  This resolution was passed with 10,432,000votes in favor, 12,000 votes against and 10,000 abstentions.

 

5.                                       Toapprove the appointment of KPMG LLP as our independent public accountants ofthe Company for the year ending October 31, 2003.  This resolution was passed with 10,438,000votes in favor, 9,000 votes against and 7,000 abstentions.

 

ITEM 6.                                   EXHIBITS AND REPORTSON FORM 8-K

 

(a)                                  Exhibits

 
| 3.1    |   | The SCO Group, Inc.’s  Amended and Restated Certificate of Incorporation (incorporated by reference  to Exhibit 3.3 to SCO’s Form 8A/A, SEC file number 000-29911)                                                      |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                              |
| 3.2    |   | The SCO Group, Inc.’s  Amended and restated bylaws (incorporated by reference to Exhibit 3.4 to  SCO’s Form 8A/A, SEC file number 000-29911)                                                                            |
|   |   |                                                                                                                                                                                                                              |
| 10.1   |   | Amendment to 2002  Omnibus Stock Incentive Plan                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                              |
| 10.2   |   | Amendment to 2000  Employee Stock Purchase Plan                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                              |
| 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. |
|   |   |                                                                                                                                                                                                                              |
| 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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(b)                                 Reports on Form 8-K

 

On May 15, 2003, wefiled a report on Form 8-K announcing our suspension of our Linux productsarising from our concerns that our UNIX code was included in Linux.

 

On May 15, 2003, wefiled a report on Form 8-K announcing preliminary results for our quarter endedApril 30, 2003.

 

ITEM 7.                                   SIGNATURES

 

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

 
| Date:  September 12, 2003 | 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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