**UNITED STATES**

 

**SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON, DC 20549**

 

**FORM 10-Q**

 

**(Markone)**

| **ý**                                                                                                                                                                                                                            | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**  |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                                                  |                                                                                          |   |
| **For the quarterly period ended APRIL 30, 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 as specified in its charter)                              |
|                                                                                 |
| **CALDERA INTERNATIONAL, INC.**                                                      |
| (Former name, former address, and  former fiscal year, if changed since last report) |
|                                                                                 |
| **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  office 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 June 12, 2003, there were 13,050,854 shares ofthe Registrant’s common stock outstanding.***

 

 

----

 

**TheSCO Group, Inc.**

 

**Tableof Contents**

 
| PART I.  | FINANCIAL INFORMATION                                                                                                                    |
|----------|------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.  | Financial Statements                                                                                                                     |
|     | Condensed Consolidated  Balance Sheets as of April 30, 2003 and October 31, 2002                                               |
|     | Condensed  Consolidated Statements of Operations and Comprehensive Loss for the three  and six months ended April 30, 2003 and 2002 |
|     | Condensed  Consolidated Statements of Cash Flows for the six months ended April 30,  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                                                                                                                 |
|     | Risk Factors                                                                                                                             |
| PART II. | OTHER  INFORMATION                                                                                                                       |
| Item 1.  | Legal  Proceedings                                                                                                                       |
| Item  2. | Changes in  Securities and Use of Proceeds                                                                                               |
| Item 6.  | Exhibits and Reports  on Form 8-K                                                                                                        |
| Item 7.  | Signatures                                                                                                                               |
|     | Officer Certification                                                                                                                    |

 

2

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** **

**THE SCOGROUP, INC. AND SUBSIDIARIES(Formerly Caldera International, Inc.)**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS****(unaudited, in thousands)**

 
|                                                                                                           |   | **April 30,  2003** | **    ** | **October 31,  2002** | **    ** |
|----------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------------------|----------------------------|--------------------|
| **ASSETS**                                                                                                     |   |                     | ** **         |                       | ** **         |
|                                                                                                           |   |                     |               |                       |               |
| CURRENT  ASSETS:                                                                                               |   |                     |               |                       |               |
| Cash  and cash equivalents                                                                                     |   | $                        | 10,015             |                       | $                  | 6,589 |   |
| Restricted  cash                                                                                               |   | 1,779                    |               | 1,428                      |               |
| Accounts  receivable, net of allowance for doubtful accounts of $324 and $348, respectively                    |   | 8,793                    |          | 8,622                      |               |
| Other  current assets                                                                                          |   | 4,392                    |               | 4,483                      |               |
| Total  current assets                                                                                          |   | 24,979                   |               | 21,122                     |               |
|                                                                                                           |   |                     |               |                       |               |
| PROPERTY  AND EQUIPMENT:                                                                                       |   |                     |               |                       |               |
| Computer  and office equipment                                                                                 |   | 3,077                    |               | 3,884                      |               |
| Leasehold  improvements                                                                                        |   | 530                      |               | 724                        |               |
| Furniture  and fixtures                                                                                        |   | 121                      |               | 201                        |               |
|                                                                                                           |   | 3,728                    |               | 4,809                      |               |
| Less  accumulated depreciation and amortization                                                                |   | (2,164                   | )                  | (2,788                     | )                  |
| Net  property and equipment                                                                                    |   | 1,564                    |               | 2,021                      |               |
|                                                                                                           |   |                     |               |                       |               |
| OTHER  ASSETS:                                                                                                 |   |                     |               |                       |               |
| Intangibles,  net                                                                                              |   | 9,689                    |               | 11,258                     |               |
| Other  assets                                                                                                  |   | 1,640                    |               | 3,005                      |               |
| Total  other assets                                                                                            |   | 11,329                   |               | 14,263                     |               |
|                                                                                                           |   |                     |               |                       |               |
| Total  assets                                                                                                  |   | $                        | 37,872             |                       | $                  | 37,406 |   |
|                                                                                                           |   |                     |               |                       |               |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                 |   |                     | ** **         |                       | ** **         |
|                                                                                                           |   |                     |               |                       |               |
| CURRENT  LIABILITIES:                                                                                          |   |                     |               |                       |               |
| Accounts  payable                                                                                              |   | $                        | 1,978              |                       | $                  | 2,467 |   |
| Royalty  payable to Novell, Inc.                                                                               |   | 1,779                    |               | 1,428                      |               |
| Accrued  payroll and benefits                                                                                  |   | 3,619                    |               | 4,089                      |               |
| Other  current liabilities                                                                                     |   | 5,709                    |               | 7,632                      |               |
| Deferred  revenue                                                                                              |   | 9,218                    |               | 10,056                     |               |
| Taxes  payable                                                                                                 |   | 758                      |               | 1,113                      |               |
| Other  royalties payable                                                                                       |   | 464                      |               | 669                        |               |
| Total  current liabilities                                                                                     |   | 23,525                   |               | 27,454                     |               |
|                                                                                                           |   |                     |               |                       |               |
| LONG-TERM  LIABILITIES                                                                                         |   | 618                      |               | 1,625                      |               |
|                                                                                                           |   |                     |               |                       |               |
| COMMITMENTS  AND CONTINGENCIES (Notes 1, 7 and 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, 12,302 and 11,412 shares  outstanding, respectively |   | 12                       |          | 11                         |          |
| Additional  paid-in capital                                                                                    |   | 215,604                  |               | 214,299                    |               |
| Warrants  outstanding                                                                                          |   | 500                      |               | 294                        |               |
| Deferred  compensation                                                                                         |   | (756                     | )                  | (644                       | )                  |
| Accumulated  other comprehensive income                                                                        |   | 736                      |               | 510                        |               |
| Accumulated  deficit                                                                                           |   | (202,517                 | )                  | (206,293                   | )                  |
| Total  stockholders’ equity                                                                               |   | 13,579                   |               | 8,177                      |               |
|                                                                                                           |   |                     |               |                       |               |
| Total  liabilities and stockholders’ equity                                                               |   | $                        | 37,872             |                       | $                  | 37,406 |   |

 

See notes tocondensed consolidated financial statements.

 

3

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**THESCO GROUP, INC. AND SUBSIDIARIES**

**(FormerlyCaldera International, Inc.)**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPE****RATIONS**

**ANDCOMPREHENSIVE INCOME (LOSS)**

**(unaudited)**

**(inthousands, except per share data)**

 
|                                                                                                            |   | **Three  Months Ended April 30,** |   | **Six Months  Ended April 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|------------|
|                                                                                                            |   | **2003**                               |   | **2002**                             | ** ** | **2003** | ** ** | **2002** | ** ** |
| REVENUE:                                                                                                        |   |                                   |   |                                 |       |   |   |   |   |
| Products                                                                                                        |   | $                                      | 11,122 |                                 | $          | 12,606 |   | $ | 22,212 |   | $ | 27,512 |   |
| Licensing                                                                                                       |   | 8,250                                  |   | —                               |       | 8,250 |   | — |   |
| Services                                                                                                        |   | 1,997                                  |   | 2,870                                |       | 4,447 |   | 5,877 |   |
| Total  revenue                                                                                                  |   | 21,369                                 |   | 15,476                               |       | 34,909 |   | 33,389 |   |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| COST  OF REVENUE:                                                                                               |   |                                   |   |                                 |       |   |   |   |   |
| Products                                                                                                        |   | 1,206                                  |   | 2,283                                |       | 2,392 |   | 4,821 |   |
| Licensing                                                                                                       |   | 2,163                                  |   | —                               |       | 2,163 |   | — |   |
| Services                                                                                                        |   | 1,778                                  |   | 3,173                                |       | 3,470 |   | 6,315 |   |
| Total  cost of revenue                                                                                          |   | 5,147                                  |   | 5,456                                |       | 8,025 |   | 11,136 |   |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| GROSS  MARGIN                                                                                                   |   | 16,222                                 |   | 10,020                               |       | 26,884 |   | 22,253 |   |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| OPERATING  EXPENSES:                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| Sales  and marketing (exclusive of stock-based compensation of $34, $56, $68 and  $113, respectively)           |   | 6,051                                  |   | 7,665                                |       | 12,491 |   | 16,036 |   |
| Research  and development (exclusive of stock-based compensation of $31, $67, $54 and  $134, respectively)      |   | 2,542                                  |   | 4,159                                |       | 5,192 |   | 9,526 |   |
| General  and administrative (exclusive of stock-based compensation of $341, $116, $496  and $257, respectively) |   | 1,462                                  |   | 2,523                                |       | 3,112 |   | 5,121 |   |
| Write-down  of investment                                                                                       |   | —                                 |   | 1,180                                |       | — |   | 1,180 |   |
| Restructuring  charges                                                                                          |   | 136                                    |   | —                               |       | (116 | ) | 4,336 |   |
| Amortization  of intangibles                                                                                    |   | 700                                    |   | 695                                  |       | 1,400 |   | 1,451 |   |
| Loss  on disposition and write-down of long-lived assets                                                        |   | —                                 |   | —                               |       | — |   | 1,328 |   |
| Stock-based  compensation                                                                                       |   | 406                                    |   | 239                                  |       | 618 |   | 630 |   |
| Total  operating expenses                                                                                       |   | 11,297                                 |   | 16,461                               |       | 22,697 |   | 39,608 |   |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| INCOME  (LOSS) FROM OPERATIONS                                                                                  |   | 4,925                                  |   | (6,441                               | )          | 4,187 |   | (17,355 | ) |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| EQUITY  IN LOSS OF AFFILIATE                                                                                    |   | (75                                    | )      | —                               |       | (100 | ) | — |   |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| OTHER  INCOME (EXPENSE):                                                                                        |   |                                   |   |                                 |       |   |   |   |   |
| Interest  income                                                                                                |   | 11                                     |   | 103                                  |       | 50 |   | 253 |   |
| Interest  expense                                                                                               |   | —                                 |   | (82                                  | )          | — |   | (208 | ) |
| Other  expense, net                                                                                             |   | (59                                    | )      | (156                                 | )          | (54 | ) | (110 | ) |
| Total  other expense, net                                                                                       |   | (48                                    | )      | (135                                 | )          | (4 | ) | (65 | ) |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| INCOME  (LOSS) BEFORE INCOME TAXES                                                                              |   | 4,802                                  |   | (6,576                               | )          | 4,083 |   | (17,420 | ) |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| PROVISION  FOR INCOME TAXES                                                                                     |   | (302                                   | )      | (55                                  | )          | (307 | ) | (217 | ) |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| NET  INCOME (LOSS)                                                                                              |   | $                                      | 4,500  |                                 | $          | (6,631 | ) | $ | 3,776 |   | $ | (17,637 | ) |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| BASIC  NET INCOME (LOSS) PER SHARE                                                                              |   | $                                      | 0.39   |                                 | $          | (0.47 | ) | $ | 0.33 |   | $ | (1.23 | ) |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| DILUTED  NET INCOME (LOSS) PER SHARE                                                                            |   | $                                      | 0.33   |                                 | $          | (0.47 | ) | $ | 0.29 |   | $ | (1.23 | ) |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| WEIGHTED  AVERAGE BASIC SHARES                                                                                  |   | 11,561                                 |   | 14,235                               |       | 11,402 |   | 14,286 |   |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| WEIGHTED  AVERAGE DILUTED SHARES                                                                                |   | 13,663                                 |   | 14,235                               |       | 13,145 |   | 14,286 |   |
|                                                                                                            |   |                                   |   |                                 |       |   |   |   |   |
| OTHER  COMPREHENSIVE INCOME (LOSS):                                                                             |   |                                   |   |                                 |       |   |   |   |   |
| Net  income (loss)                                                                                              |   | $                                      | 4,500  |                                 | $          | (6,631 | ) | $ | 3,776 |   | $ | (17,637 | ) |
| Foreign  currency translation adjustments                                                                       |   | 69                                     |   | 131                                  |       | 226 |   | (53 | ) |
| COMPREHENSIVE  INCOME (LOSS)                                                                                    |   | $                                      | 4,569  |                                 | $          | (6,500 | ) | $ | 4,002 |   | $ | (17,690 | ) |

 

See notes tocondensed consolidated financial statements.

 

4

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**THE SCOGROUP, INC. AND SUBSIDIARIES**

**(FormerlyCaldera International, Inc.)**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF CAS****H FLOWS**

**(unaudited,in thousands)**

 
|                                                                                                             |   | **Six Months  Ended April 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|------------|
|                                                                                                             |   | **2003**                             |       | **2002** | ** ** |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                                           |   |                                 |       |   |   |
| Net  income (loss)                                                                                               |   | $                                    | 3,776      |   | $ | (17,637 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities:             |   |                                 |       |   |   |
| Amortization  of goodwill and intangibles (including $169 and $168 classified as cost of  revenue, respectively) |   | 1,569                                |       | 1,619 |   |
| Depreciation  and amortization                                                                                   |   | 604                                  |       | 1,528 |   |
| Stock-based  compensation                                                                                        |   | 618                                  |       | 630 |   |
| Loss  on disposition and write-down of long-lived assets                                                         |   | —                               |       | 1,328 |   |
| Equity  in loss of affiliate                                                                                     |   | 100                                  |       | — |   |
| Write-down  of investment                                                                                        |   | —                               |       | 1,180 |   |
| Amortization  of debt discount                                                                                   |   | —                               |       | 207 |   |
| Changes  in operating assets and liabilities, net of effect of disposition of SCO  Group, Ltd.                   |   |                                 |       |   |   |
| Accounts  receivable, net                                                                                        |   | (348                                 | )          | 10,557 |   |
| Other  current assets                                                                                            |   | 1,193                                |       | (148 | ) |
| Other  assets                                                                                                    |   | 493                                  |       | 381 |   |
| Accounts  payable                                                                                                |   | (217                                 | )          | (465 | ) |
| Payable  to Tarantella, Inc.                                                                                     |   | —                               |       | (107 | ) |
| Accrued  payroll and benefits                                                                                    |   | (18                                  | )          | (2,170 | ) |
| Other  current liabilities                                                                                       |   | (2,034                               | )          | 918 |   |
| Deferred  revenue                                                                                                |   | (838                                 | )          | (527 | ) |
| Taxes  payable                                                                                                   |   | 49                                   |       | (278 | ) |
| Other  royalties payable                                                                                         |   | (205                                 | )          | (541 | ) |
| Other  long-term liabilities                                                                                     |   | (903                                 | )          | 2,313 |   |
| Net  cash provided by (used in) operating activities                                                             |   | 3,839                                |       | (1,212 | ) |
|                                                                                                             |   |                                 |       |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                                           |   |                                 |       |   |   |
| Purchase  of property and equipment                                                                              |   | (328                                 | )          | (59 | ) |
| Proceeds  from available-for-sale securities                                                                     |   | —                               |       | 5,943 |   |
| Cash  paid to wind up SCO Group, Ltd.                                                                            |   | (666                                 | )          | — |   |
| Investment  in and loans to Vista                                                                                |   | (450                                 | )          | — |   |
| Net  cash provided by (used in) investing activities                                                             |   | (1,444                               | )          | 5,884 |   |
|                                                                                                             |   |                                 |       |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                                           |   |                                 |       |   |   |
| Repayments  of long-term debt                                                                                    |   | —                               |       | (5,000 | ) |
| Proceeds  from sale of common stock through ESP program                                                          |   | 57                                   |       | 229 |   |
| Purchase  of common shares from existing stockholders                                                            |   | —                               |       | (555 | ) |
| Issuance  of a warrant                                                                                           |   | 500                                  |       | — |   |
| Proceeds  from exercise of common stock options                                                                  |   | 225                                  |       | 112 |   |
| Net  cash provided by (used in) financing activities                                                             |   | 782                                  |       | (5,214 | ) |
|                                                                                                             |   |                                 |       |   |   |
| NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                            |   | 3,177                                |       | (542 | ) |
| EFFECT  OF FOREIGN EXCHANGE RATES ON CASH                                                                        |   | 249                                  |       | (67 | ) |
| CASH  AND CASH EQUIVALENTS, beginning of period                                                                  |   | 6,589                                |       | 22,435 |   |
| CASH  AND CASH EQUIVALENTS, end of period                                                                        |   | $                                    | 10,015     |   | $ | 21,826 |   |
|                                                                                                             |   |                                 |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                                               |   |                                 |       |   |   |
|                                                                                                             |   |                                 |       |   |   |
| Cash  paid for taxes                                                                                             |   | $                                    | 249        |   | $ | 385 |   |

 

See notes tocondensed consolidated financial statements.

 

5

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**THESCO GROUP, INC. AND SUBSIDIARIES**

**(FormerlyCaldera International, Inc.)**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIA****L 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 ownCaldera Systems and to acquire substantially all of the assets, liabilities andoperations of the server and professional services groups of Tarantella, Inc.(“Tarantella”), formerly The Santa Cruz Operation, Inc., pursuant to anAgreement and Plan of Reorganization (the “Reorganization Agreement”), dated asof August 1, 2000, as amended. Under the Reorganization Agreement, Caldera acquired the tangible andintangible assets used in the server and professional services groups,including all of the capital stock of certain Tarantella subsidiaries.  In connection with the formation of Caldera,Caldera Systems became a wholly-owned subsidiary of Caldera.  All shares of Caldera Systems’ common stock,as well as options to purchase shares of Caldera Systems’ common stock, wereconverted into the same number of shares of common stock of Caldera and optionsto purchase shares of common stock of Caldera.

 

The acquired operationsfrom Tarantella developed and marketed server software related to networkedbusiness computing and were one of the leading providers of UNIX serveroperating systems.  In addition, theseoperations provided professional services related to implementing and maintainingUNIX system software products.  Theacquisition provided Caldera with international offices and a distributionchannel with resellers throughout the world. Subsequent to this acquisition, the Company has primarily sold UNIXbased products and services.

 

On May 16, 2003, Caldera’s stockholdersapproved an amendment to Caldera’s certificate of incorporation that changedCaldera’s name to The SCO Group, Inc. (the “Company”).

 

The Company’s business continues to focuson developing and marketing reliable, cost-effective UNIX software products andrelated services and web services for the small to medium business market.  The Company is pursuing its SCOx strategy toprovide a common framework for the integration of internet applications (webservices) and server based applications. In addition to SCOx, the Company established SCOsource inJanuary 2003 to review and enforce its intellectual property surroundingthe UNIX operating system.  The Companyacquired the intellectual property rights to UNIX from Tarantella.

 

The Company will continue to market SCOOpenServer and SCO UnixWare products and sell these 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 accompanyingunaudited condensed consolidated financial statements of the Company have beenprepared by the Company pursuant to the rules and regulations of the Securitiesand Exchange Commission (“SEC”) on a basis consistent with the Company’saudited annual financial statements, and, in the opinion of management, reflectall adjustments, consisting of normal recurring adjustments, necessary topresent fairly the financial information set forth therein.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to SEC rules and regulations, although theCompany believes that the following disclosures, when read in conjunction withthe audited annual financial statements and the notes thereto included in theCompany’s most recent annual report on Form 10-K, are adequate to make theinformation presented not misleading.

 

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

### ** **

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during thereporting period.  Actual results coulddiffer from these estimates.  TheCompany’s critical accounting policies and estimates, as discussed in theCompany’s most recent annual report on Form 10-K and related amendments,include, among others, revenue recognition, income taxes and related valuationallowances, impairment of long-lived assets and allowances for doubtfulaccounts and product returns.

 

### **RevenueRecognition**

### ** **

The Company’s revenue hashistorically been from two sources: (i) product license revenue, primarily fromproduct sales to resellers and end users, and royalty revenue from productsales by source code OEMs; and (ii) service and support revenue, primarily fromproviding software updates, support and education and consulting services toend users.  During the quarter endedApril 30, 2003, the Company recognized its first licensing revenue from itsintellectual property initiative, SCOsource.

 

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

 

For contracts involvingmultiple elements (i.e., delivered and undelivered products, maintenance andother services), the Company allocates revenue to each component of thecontract based on objective evidence of its fair value, which is specific tothe Company.  The fair value of eachelement is based on amounts 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 SCOsourcelicensing revenue to date has been generated from license agreements that arenon-exclusive, perpetual, royalty-free, paid up licenses to utilize the

 

7

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Company’s UNIX source code, including the right to sublicense.  The Company recognizes revenue fromlicensing agreements 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 arereceived.

 

The Company recognizesrevenue from maintenance fees for ongoing customer support and product updatesratably over the period of the maintenance contract.  Payments for maintenance fees are generally made in advance andare non-refundable.  For revenueallocated to education and consulting services or derived from the separatesale of such services, the Company recognizes revenue as the related servicesare performed.

 

The Company recognizesproduct revenue from royalty payments upon receipt of royalty reports from OEMsrelated to their product sales.

 

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

 

Basic net income (loss)per common share (“Basic EPS”) is computed by dividing net income (loss) by theweighted average number of common shares outstanding.  Diluted net income (loss) per common share (“Diluted EPS”) iscomputed by dividing net income (loss) by the sum of the weighted averagenumber of common shares outstanding and the dilutive potential common shareequivalents then outstanding.  Potentialcommon share equivalents consist of the weighted average of shares issuableupon the exercise of outstanding stock options.  The following table is a reconciliation of the numerator anddenominator of Basic EPS to the numerator and denominator of Diluted EPS (inthousands, except per share amounts):

 
|                                             |   | **Three Months Ended April 30,** |   | **Six Months Ended April 30,** |   |
|--------------------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                             |   | **2003**                              |   | **2002**                            |   | **2003** |   | **2002** |   |
|                                             |   |                                  |   |                                |   |   |   |   |   |
| Numerator:                                       |   |                                  |   |                                |   |   |   |   |   |
| Net  income (loss)                               |   | $                                     | 4,500  |                                | $      | (6,631 | ) | $ | 3,776 |   | $ | (17,637 | ) |
|                                             |   |                                  |   |                                |   |   |   |   |   |
| Denominator:                                     |   |                                  |   |                                |   |   |   |   |   |
| Weighted  average shares outstanding             |   | 11,561                                |   | 14,235                              |   | 11,402 |   | 14,286 |   |
| Effect  of stock options                         |   | 1,779                                 |   | —                              |   | 1,476 |   | — |   |
| Effect  of restricted stock awards               |   | 299                                   |   | —                              |   | 255 |   | — |   |
| Effect  of warrant                               |   | 24                                    |   | —                              |   | 12 |   | — |   |
| Total                                            |   | 13,663                                |   | 14,235                              |   | 13,145 |   | 14,286 |   |
|                                             |   |                                  |   |                                |   |   |   |   |   |
| Basic  EPS                                       |   | $                                     | 0.39   |                                | $      | (0.47 | ) | $ | 0.33 |   | $ | (1.23 | ) |
| Diluted  EPS                                     |   | 0.33                                  |   | (0.47                               | )      | 0.29 |   | (1.23 | ) |
|                                             |   |                                  |   |                                |   |   |   |   |   |
| Excluded  anti-dilutive common share equivalents |   | 628                                   |   | 2,672                               |   | 987 |   | 2,817 |   |

 

8

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**(3)OTHER CURRENT ASSETS**

 

Other current assetsinclude the following as of April 30, 2003 and October 31, 2002 (inthousands):

 
|                                                       |   | **April 30,  2003** |   | **October 31,  2002** | ** ** |
|------------------------------------------------------------|--------|--------------------------|--------|----------------------------|------------|
|                                                       |   |                     |   |                       |       |
| Notes  receivable and accrued interest from Vista (Note 5) |   | $                        | 1,259  |                       | $          | — |   |
| Prepaid  expenses                                          |   | 1,763                    |   | 1,273                      |       |
| VAT  receivable                                            |   | 162                      |   | 1,556                      |       |
| Other                                                      |   | 1,208                    |   | 1,654                      |       |
| Total                                                      |   | $                        | 4,392  |                       | $          | 4,483 |   |

 

**(4)INTANGIBLE ASSETS**

 

In July 2001, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 142, “Goodwill and Other IntangibleAssets.”  Under SFAS No. 142, goodwilland other intangible assets with indefinite lives are no longer amortized, butrather are assessed annually for impairment. The Company adopted SFAS No. 142 on November 1, 2001, the beginningof fiscal year 2002.  All of theCompany’s identifiable intangible assets are deemed to have finite lives andare amortized over their remaining useful lives.

 

Intangible assets are theresult of the acquisition of certain assets and operations from Tarantella andthe acquisition of the WhatIfLinux technology from Acrylis, Inc.  Upon adoption of SFAS No. 142, the Companyreassessed the useful lives of its intangible assets and related fair valuesand reduced the carrying value of its goodwill to $0.

 

The following tablesummarizes the remaining components of amortized intangible assets and theiruseful lives as of April 30, 2003 (in thousands):

 
|                              |   | **Estimated  Useful Life** |   | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** |
|-----------------------------------|--------|----------------------------|--------|-----------------------------|------------|-------------------------------|------------|---------------------|------------|
| Amortized  intangible assets:     |   |                       |   |                        |       |                          |       |                |       |
| Distribution/reseller  channel    |   | 5 years                    |   | $                           | 11,626     |                          | $          | 3,513               |       | $ | 8,113 |   |
| Acquired  technology - Tarantella |   | 5 years                    |   | 1,687                       |       | 510                           |       | 1,177               |       |
| Acquired  technology - Acrylis    |   | 2 years                    |   | 871                         |       | 655                           |       | 216                 |       |
| Trade  name and trademarks        |   | 5 years                    |   | 261                         |       | 78                            |       | 183                 |       |
| Total  intangible assets          |   |                       |   | $                           | 14,445     |                          | $          | 4,756               |       | $ | 9,689 |   |

 

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

 

DuringAugust 2002, the Company entered into a license agreement with CommunityIQ.com d/b/a Vista.com (“Vista”).  Underthe agreement, the Company acquired an exclusive license from Vista to sell andmarket Vista’s web services solutions to the Company’s channel partners.  The Company prepaid $100,000 of royaltiesunder the license agreement and advanced $250,000 to Vista in connection with aright to purchase 3,313,000 shares of Vista’s Series C convertible preferredstock for $500,000 (see below). Additionally, the Company acquired a $1,000,000 convertible notereceivable payable by Vista that bears interest at 8 percent and is due

 

9

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on August 15, 2003.  The $1,000,000 note receivable was acquiredfrom Vista’s founder and majority stockholder in exchange for 800,000 shares ofthe Company’s common stock (which had an estimated fair value of $900,000) and$100,000 in cash.  The note receivableis guaranteed by Vista’s founder and majority stockholder and is convertible atthe Company’s option into a 20 percent fully diluted interest in Vista.  The note receivable and related accruedinterest are included in other current assets (see Note 3).

 

InDecember 2002, the Company and Vista entered into a Stock PurchaseAgreement, pursuant to which the Company acquired 3,313,000 shares of Vista’sSeries C preferred stock for $500,000. The 3,313,000 shares of Series C preferred stock represent a 10 percentfully diluted interest in Vista.  The$250,000 advance discussed above was applied toward the purchase and duringJanuary 2003 the remaining $250,000 was paid.  Additionally, the Company and Vista entered into an Agreement andPlan of Merger pursuant to which the Company received an option throughMarch 31, 2003 to acquire the remaining 70 percent ownership interest ofVista in exchange for 2,500,000 shares of the Company’s common stock.  The Company also received the right to representationon Vista’s board of directors.  Theoption to purchase the remaining 70 percent of Vista expired unexercised onMarch 31, 2003.

 

InJanuary 2003, the Company advanced Vista $100,000 in the form of apromissory note due on April 14, 2003. On April 2, 2003, the maturity date on this promissory note wasextended to April 30, 2003.  Thispromissory note bears interest at 8 percent payable at maturity and isconvertible at the Company’s option into a 5 percent fully diluted interest inVista.  On April 2, 2003, theCompany advanced Vista an additional $100,000 in the form of a promissory notedue on April 30, 2003.  Thepromissory note bears interest at 8 percent payable at maturity and isconvertible at the Company’s option into a 5 percent fully diluted interest inVista.  As of April 30, 2003, both$100,000 notes were outstanding and in technical default; however, the Companyhad not demanded repayment pending management’s decision whether or not to exercisethe conversion rights for an additional equity interest in Vista.  The Company and Vista continue to worktogether under the license agreement discussed above.

 

Asa result of the Company’s current 10 percent ownership interest in Vista, theright to representation on Vista’s board of directors, and the convertiblefeatures of the notes receivable from Vista, the Company has accounted for itsinterest in Vista using the equity method of accounting.  Under the equity method, the Companyrecognizes its portion of the net income or net loss of Vista in itsconsolidated statements of operations. Accordingly, during the quarter ended January 31, 2003, the Companyrecognized $25,000 equity in loss of affiliate and during the quarter endedApril 30, 2003, the Company recognized $75,000 equity in loss ofaffiliate.

 

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

### ** **

As of April 30, 2003and October 31, 2002, other accrued liabilities consisted of the following(in thousands):

 
|                                          |   | **April 30,  2003** |       | **October 31,  2002** |       |
|-----------------------------------------------|--------|--------------------------|------------|----------------------------|------------|
|                                          |   |                     | ** ** |                       | ** ** |
| Co-operative  advertising                     |   | $                        | 1,453      |                       | $          | 1,630 |   |
| Accrual  for unvouchered payables             |   | 1,866                    |       | 1,824                      |       |
| Restructuring  accrual – current portion |   | 274                      |       | 1,113                      |       |
| Other                                         |   | 2,116                    |       | 3,065                      |       |
| Total                                         |   | $                        | 5,709      |                       | $          | 7,632 |   |

 

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**(7)RESTRUCTURING PLANS**

 

The Company’s board of directorshas adopted restructuring plans to reduce facilities and personnel.  These restructuring plans have resulted inthe Company recording restructuring accruals for the costs associated with thereduction in facilities and for severance costs of affected employees.

 

In March 2003, inconnection with management’s decision to establish strategic Europeanheadquarters in Dublin, Ireland, and the Company’s United Kingdom (“UK”)subsidiary, SCO Group, Ltd, not performing at expected levels, the Company determinedthat SCO Group, Ltd would be wound up. On March 26, 2003, the board of directors of SCO Group, Ltd.,obtained administrative relief in accordance with Rule 2.2 of the InsolvencyRules 1986 of the UK.  In connectionwith the approved administrative relief, the operations of SCO Group, Ltd. weretransferred to an administrator that was appointed by the court to complete thewinding-up process.  As ofApril 30, 2003, the operations of SCO Group, Ltd were no longer under thecontrol of the Company and the Company had been released of any liabilities inexchange for the net assets of SCO Group, Ltd. The Company has included in its statement of operations for the threeand six months ended April 30, 2003, the operations for SCO Group, Ltd.,for the entire periods.

 

In connection with thewinding-up of SCO Group, Ltd.’s operations, the Company incurred charges forseverance and related payments for employees totaling $972,000.  As a result of the administrative relief andtransfer of SCO Group, Ltd to the administrator, the Company reversed $836,000of previously recorded accruals related to the leased facilities in the UK, ofwhich $415,000 was recorded 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 tablesummarizes the activity related to the restructuring accruals during the sixmonths ended April 30, 2003 (in thousands): 

 
|                                                            |   | **Balance as of  October 31,  2002** |       | **Additions** |       | **Payments** |       | **Adjustments** |       | **Balance as of  April 30,  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                                       |       | —        |       | (362         | )          | (147            | )          | 452                                     |       |
| Restructuring  accrual during quarter ended  Apr. 30, 2003      |   | —                                    |       | 972           |       | (907         | )          | —          |       | 65                                      |       |
| Total                                                           |   | $                                         | 1,787      |          | $          | 972          |       | $               | (1,569     | )                                       | $          | (673 | ) | $ | 517 |   |

 

The adjustments relatedto the July 31, 2002 and October 31, 2002 accruals totaling $149,000represent the difference between actual payments made and estimated accrualsfor severance costs for international employees.  The adjustments related to the October 31, 2001 and

 

11

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January 31, 2002 accruals totaling $524,000 represent facilitiesaccruals reversed as the Company was successful in negotiating leaseterminations for two of its facilities (one in the United States and one in theUK as discussed above) that had been vacated in connection with previouscorporate restructurings.

 

At the time of therestructurings discussed above, the accruals recorded were management’s bestestimate of the future costs.  As ofApril 30, 2003, the remaining accrual relates primarily to future leasepayments for vacated facilities and will be relieved as the lease payments aremade in accordance with the lease terms through 2005.

 

**(8) COMMITMENTS AND CONTINGENCIES**

 

**Litigation**

 

Beginning inJuly 2001, the Company, certain of its officers and directors, and theunderwriters of the Company’s initial public offering were named as defendantsin a series of class action lawsuits filed in the United States District Courtfor the Southern District of New York (the “Actions”) by parties allegingviolations of the securities laws.  Thecomplaints were subsequently amended and consolidated into a singlecomplaint.  The consolidated complaintalleges certain improprieties regarding the circumstances surrounding theunderwriters’ conduct during the Company’s initial public offering and thefailure to disclose such conduct in the registration statement in violation ofthe Securities Act of 1933, as amended. The consolidated complaint also alleges that, whether or not theCompany’s officers or directors were aware of the underwriters’ conduct, theCompany and those officers and directors have statutory liability under thesecurities laws for issuing a registration statement in connection with theCompany’s initial public offering that failed to disclose that conduct.

 

The 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.  InSeptember 2002, the plaintiffs agreed to dismiss the individualdefendants, but may elect to bring the individual defendants back into the caseat a later date.  Management believesthat the claims against the Company and any of its officers and directors arewithout legal merit and intend to defend them vigorously.  The Company is not aware of any improperconduct by the Company, its officers and directors, or its underwriters, andthe Company denies any liability relating thereto.  In addition, the Company’s underwritingagreement with its underwriter provides for the indemnification of the Companyand its officers and directors for liabilities arising out of misstatements inits registration statement attributable to material non-disclosures by theunderwriters.  The Company also maintainsliability insurance coverage that is expected to substantially cover the costsof defending the claims, once the retention amount has been expended.  During the six months ended April 30,2003, the Company had paid and/or accrued the full retention amount of$200,000.

 

The Company has notified itsunderwriters and insurance companies of the existence of the claims.  The initial round of motions to dismissunder the securities laws were recently denied on the basis that the Plaintiffshad alleged, but not proven, proper causes of action.  The actions are now in the discovery phase oflitigation.  Management believes, afterconsultation with legal counsel, that the ultimate outcome of this matter willnot have a material adverse effect on the Company’s results of operations orfinancial position.

 

12

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In April, 2003, a former Indiandistributor of the Company filed a claim in the City Court of Bangalore, Indiarequesting summary judgment for payment of $1,428,000, and order that theCompany trade in India only through the distributor until the claim isfulfilled.  The distributor claims thatthe Company is responsible to repurchase certain software products and toreimburse the distributor for certain other operating costs.  Management does not believe that the Companyis responsible to reimburse the distributor for any operating costs and alsobelieves that the return rights related to any remaining inventory havelapsed.  In accordance with theCompany’s revenue recognition policy, revenue related to the inventory with thedistributor is included in deferred revenue as of April 30, 2003.  Management has engaged local counsel who hasadvised that it is likely that the current claims will fail, but that the distributorwill continue to pursue their claims either in the Indian courts or in the UScourts.  Management believes, afterconsultation with legal counsel, that the ultimate outcome of this matter willnot have a material adverse effect on the Company’s results of operations orfinancial position.

 

On March 6, 2003,the Company filed a complaint against IBM alleging breach of contract,misappropriation of trade secrets, tortious interference, and unfaircompetition.  The complaint centers onIBM’s activities regarding the UNIX operating system that underlies both theCompany’s UNIX-based operating systems and IBM’s AIX, its UNIX-based operatingsystem.  The complaint alleges that IBMobtained information concerning the UNIX source code from the Company and inappropriatelyused and distributed that information in connection with its efforts to promotethe Linux operating system.  Thecomplaint seeks damages in excess of $1 billion dollars.

 

The Company has providedIBM notice that the Company will have the authority to revoke its UNIX licenseagreement that underlies their AIX software on June 13, 2003, unless IBMcures the claims that the Company has asserted.  In addition, the Company has publicly, and in individual lettersto 1,500 of the largest corporations, cautioned users of Linux that there are unresolvedintellectual property issues surrounding Linux that may expose them tounanticipated liability.  As a result ofthese concerns, the Company suspended sales of its Linux products.

 

IBM has filed itsresponse to the complaint, including a demand for jury trial, but there hasbeen no discovery to date.  IBM has alsoremoved the action from Utah Third District State Court to the Federal DistrictCourt for the District of Utah.

 

Pursuit of the litigationagainst IBM and, potentially, others will be costly, and management expects thecosts for legal fees could be substantial. In addition, the Company may experience a decrease in revenue as aresult of the loss of sales of Linux products and initiatives previouslyundertaken jointly with IBM and others affiliated with IBM.  The Company anticipates that participants inthe Linux industry will seek to influence participants in the markets in whichwe sell our products to reduce or eliminate the amount of our products andservices that they purchase.  There isalso a risk that the assertion of the Company’s intellectual property rightswill be negatively viewed by participants in our marketplace and we may losesupport from such participants.  Any ofthe foregoing could adversely affect the Company’s position in the marketplaceand our results of operations.  Theultimate outcome or potential effect on the Company’s results of operations orfinancial position is not currently known or determinable.

 

The Company is a party tocertain other legal proceedings arising in the ordinary course ofbusiness.  Management believes, afterconsultation with legal counsel, that the ultimate

 

13

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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**

 

During the three and sixmonths ended April 30, 2003, the Company granted 774,000 and 1,113,000stock options with average exercise prices of $2.07 and $1.90, respectively,per share.  None of these stock optionswere granted at prices that were below the quoted market price on the date ofgrant.  During the three and six monthsended April 30, 2003, 117,000 and 247,000 options to purchase shares of commonstock were exercised with average exercise prices of $0.86 and $0.91,respectively, per share.  As ofApril 30, 2003, there were 4,299,000 stock options outstanding with aweighted average exercise price of $2.10 per share.

 

Amortization of deferredcompensation was $239,000 and $396,000, respectively, during the three and sixmonths ended April 30, 2003 and $216,000 and $431,000, respectively,during the three and six months ended April 30, 2002.

 

During the quarter endedApril 30, 2003, the Company’s board of directors approved a resolution toreceive remaining amounts owed to them for services provided during the 2002fiscal year in the form of restricted stock awards.  The Company issued 27,500 shares of restricted common stock witha fair value of $36,000.  The fair valueof the restricted stock was recorded as stock-based compensation for the threeand six months ended April 30, 2003.

 

During the six monthsended April 30, 2003, the Company issued 218,000 shares of restrictedstock to certain key employees and 150,000 shares of restricted common stock tomembers of the Company’s board of directors. The restricted common stock issued to the board of directors was in lieuof cash compensation for their services to the Company during the 2003 fiscal yearand the restrictions lapse at October 31, 2003.  The restrictions on the restricted stock awards granted to keyemployees lapse over a period of 24 months. The fair value of the restricted stock awards granted of $549,000 wasrecorded as a component of deferred compensation and is amortized tostock-based compensation as the restrictions lapse or as the services areperformed.

 

During the six monthsended April 30, 2003, the Company issued a ten-year option to acquire100,000 shares of the Company’s common stock at $1.52 per share to a consultantfor services.  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 April 30,2003, the Company recorded $131,000 of expense related to this option.  For the six months ended April 30,2003, the Company recorded $186,000 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 April 30, 2003 were the following: estimated fair valueof common stock of $2.66 per share; risk-free interest rate of three percent;expected dividend yield of 0 percent; volatility of 232 percent; and expectedexercise life of ten years.

 

During the three and sixmonths ended April 30, 2002, the Company agreed to extend the exerciseperiod for options held by certain employees that were terminated.  The Company

 

14

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recorded $23,000 and $73,000, respectively, of compensation expenserelated to these modifications.

 

The following tabledetails the components of stock-based compensation for the three and six monthsended April 30, 2003 and 2002 (in thousands):

 
|                                   |   | **Three Months Ended April 30,** |       | **Six Months Ended April 30,** |       |
|----------------------------------------|--------|---------------------------------------|------------|-------------------------------------|------------|
|                                   |   | **2003**                              |       | **2002**                            | ** ** | **2003** | *** *** | **2002** | *** *** |
|                                   |   |                                  | ** ** |                                | ** ** |   | ** ** |   | ** ** |
| Amortization  of deferred compensation |   | $                                     | 239        |                                | $          | 216 |   | $ | 396 |   | $ | 431 |   |
| Option  to consultant                  |   | 131                                   |       | —                              |       | 186 |   | — |   |
| Options  and shares for services       |   | 36                                    |       | —                              |       | 36 |   | 126 |   |
| Modifications  to options              |   | —                                |       | 23                                  |       | — |   | 73 |   |
| Total                                  |   | $                                     | 406        |                                | $          | 239 |   | $ | 618 |   | $ | 630 |   |

 

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

 

SFAS No. 148, “Accountingfor Stock-Based Compensation” 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 ofthe stock options is estimated on the date of grant using the Black-Scholesoption-pricing model.

 

With respect to stock options andrestricted stock awards granted during the three and six months endedApril 30, 2003, the assumptions used to estimate fair value were asfollows: risk-free interest rate of 2.85 percent; expected dividend yield of 0percent; volatility of 142 percent and 115 percent, respectively; and expectedexercise life of 2.3 years.

 

With respect to the stock options grantedduring the three and six months ended April 30, 2002, the assumptions usedto estimate fair value were as follows: risk-free interest rate of 3.3 percent;expected dividend yield of 0 percent; volatility of 115 percent and 142percent, respectively; and expected exercise life of 4.3 years.

 

For purposes of the pro forma disclosure,the estimated fair value of the stock options and restricted stock awards areamortized over the vesting period of the award.  The following is the pro forma disclosure and the related impacton net income (loss) and the net income (loss) per share for the three and sixmonths ended April 30, 2003 and 2002 (in thousands, except per shareamounts):

 
|                                                      |   | **Three Months Ended April 30,** |       | **Six Months Ended April 30,** |       |
|-----------------------------------------------------------|--------|---------------------------------------|------------|-------------------------------------|------------|
|                                                      |   | **2003**                              |       | **2002**                            | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                      |   |                                  | ** ** |                                | ** ** |   | ** ** |   | ** ** |
| Net  income (loss):                                       |   |                                  |       |                                |       |   |   |   |   |
| As  reported                                              |   | $                                     | 4,500      |                                | $          | (6,631 | ) | $ | 3,776 |   | $ | (17,637 | ) |
| Stock-based  compensation included in reported net income |   | 406                                   |       | 239                                 |       | 618 |   | 630 |   |
| Fair  value of stock-based compensation                   |   | (412                                  | )          | (974                                | )          | (975 | ) | (1,927 | ) |
| Pro  forma                                                |   | $                                     | 4,494      |                                | $          | (7,366 | ) | $ | 3,419 |   | $ | (18,934 | ) |
|                                                      |   |                                  |       |                                |       |   |   |   |   |
| Net  income (loss) per diluted share:                     |   |                                  |       |                                |       |   |   |   |   |
| As  reported                                              |   | $                                     | 0.33       |                                | $          | (0.47 | ) | $ | 0.29 |   | $ | (1.23 | ) |
| Pro  forma                                                |   | $                                     | 0.33       |                                | $          | (0.52 | ) | $ | 0.26 |   | $ | (1.33 | ) |

 

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**Warrant Agreement**

 

During the quarter endedApril 30, 2003, the Company issued a warrant to a SCOsource licensee.  The warrant allows the licensee to acquire210,000 shares of the Company’s common stock at an exercise price of $1.83 pershare for a term of five years from the date of grant.  Because the warrant was issued for noconsideration to the SCOsource licensee, the Company has recorded the fairvalue of the warrant of $500,000, as determined using the Black-Scholesoption-pricing model, as a warrant outstanding during the quarter endedApril 30, 2003 and reduced license revenue accordingly.  Assumptions used in the Black-Scholesoption-pricing model to estimate fair value were the following: estimated fairvalue of common stock of $2.40 per share; risk-free interest rate of threepercent; expected dividend yield of 0 percent; volatility of 236 percent; andterm of 5 years.

 

**Warrant Agreement with Morgan Keegan**

 

InAugust 2002, the Company entered into an agreement with Morgan Keegan& Company (“Morgan Keegan”) to act as an exclusive financial advisor toassist the Company in its analysis, consideration and if appropriate, executionof various financial and strategic alternatives including, but not limited to,securing additional equity and/or debt capital and potential strategictransactions including mergers, acquisitions and joint ventures.

 

Inconsideration for the services provided, the Company issued to Morgan Keegan awarrant to purchase 200,000 shares of the Company’s common stock at an exerciseprice of $0.01 per share.  Morgan Keeganwas granted demand registration rights to have the Company use its best effortsto register the shares upon exercise of the warrant.  In the event that the Company is successful in raising equity, itwill have a contingent fee owed to Morgan Keegan for six percent of theprincipal amount of the financing.  Ifthe Company is successful in raising mezzanine financing (convertible debt)and/or senior debt, it will have a contingent fee owed to Morgan Keegan ofthree percent and one percent, respectively, of the amounts borrowed.  In the event that the Company is successfulin completing an acquisition, it will have a contingent fee owed to MorganKeegan for the greater of two percent of the transaction value or $250,000.

 

DuringAugust 2002, Morgan Keegan executed the warrant agreement.  Upon execution of the warrant agreement, theCompany expensed the fair value of the warrant of $294,000, determinedusing the Black-Scholes option-pricing model. Assumptions used in the Black-Scholes option-pricing model were thefollowing: estimated fair value of common stock of $1.47 per share; risk-freeinterest rate of three percent; expected dividend yield of 0 percent;volatility of 145 percent; and expected exercise life of three months.  During the six months ended April 30,2003, Morgan Keegan exercised the warrant.

 

**EmployeeStock Purchase Plan**

 

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

 

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

 

On April 30, 2003,the Company and Center 7, Inc., (“C7”) entered into a Marketing andDistribution Master Agreement (the “Marketing Agreement”) and an AssignmentAgreement.  C7 is majority owned by TheCanopy Group, Inc. (“Canopy”), who is the Company’s principal stockholder.  Under the Marketing Agreement, the Companywas appointed as a worldwide distributor for C7 products and will co-brand,market and distribute these products. The Company will pay C7 a royalty on all products sold.  Under the Assignment Agreement, the Companyassigned C7 the copyright applications, trademarks, patents and contractsrelated to Volution Manager, Volution Authentication, Volution Online andVolution Manager Update Service (collectively, the “Assigned Software”).  As consideration for this assignment, C7issued to the Company a $500,000 non-recourse promissory note, secured by the AssignedSoftware, due on April 30, 2005 with interest payable at a rate of onepercent above the prime rate as reported in the Wall Street Journal.

 

During the time theCompany was developing the Assigned Software, it had expensed all amounts forits research and development efforts. As a result, at the time the promissory note was executed, the Companyhad no recorded basis in the Assigned Software.  Because the transfer of the Assigned Software was to a relatedparty in exchange for a promissory note, no gain will be recognized by theCompany until payments are received.

 

**(11)SIGNIFICANT CUSTOMERS**

 

During the three and sixmonths ended April 30, 2003, two customers accounted for approximately 39percent and 24 percent, respectively, of the Company’s total revenue.  There were no outstanding receivables fromthese two customers as of April 30, 2003. During the three and six months ended April 30, 2002, the Companydid not have any customers that accounted for more than 10 percent of totalrevenue.

 

**(12) SEGMENT INFORMATION**

 

The Company’s resourcesare allocated and operating results managed to the operating income (loss)level for each of the Company’s three geographic units.  The geographic units consist of theAmericas, 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.

 

17

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Segment disclosures forthe Company’s operating divisions are as follows for the three and six monthsended April 30, 2003 and 2002 (in thousands):

 
|                           |   | **Three Months Ended April 30, 2003** |       |
|--------------------------------|--------|--------------------------------------------|------------|
|                           |   | **Americas**                               |       | **EMEA** | ** ** | **Asia** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                           |   |                                       | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Revenue                        |   | $                                          | 6,710      |   | $ | 4,576 |   | $ | 1,759 |   | $ | 8,324 |   | $ | 21,369 |   |
| Cost  of revenue               |   | 1,357                                      |       | 922 |   | 332 |   | 2,536 |   | 5,147 |   |
| Gross  margin                  |   | 5,353                                      |       | 3,654 |   | 1,427 |   | 5,788 |   | 16,222 |   |
| Sales  and marketing           |   | 2,375                                      |       | 2,778 |   | 892 |   | 6 |   | 6,051 |   |
| Research  and development      |   | 1,300                                      |       | 887 |   | 341 |   | 14 |   | 2,542 |   |
| General  and administrative    |   | 748                                        |       | 510 |   | 196 |   | 8 |   | 1,462 |   |
| Other                          |   | —                                     |       | — |   | — |   | 1,242 |   | 1,242 |   |
| Total  operating expenses      |   | 4,423                                      |       | 4,175 |   | 1,429 |   | 1,270 |   | 11,297 |   |
| Income  (loss) from operations |   | $                                          | 930        |   | $ | (521 | ) | $ | (2 | ) | $ | 4,518 |   | $ | 4,925 |   |
|                           |   |                                       |       |   |   |   |   |   |   |   |   |
|                           |   | **Three Months Ended April 30, 2002** | ** ** |
|                           |   | **Americas**                               |       | **EMEA** | ** ** | **Asia** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                           |   |                                       |       |   |   |   |   |   |   |   |   |
| Revenue                        |   | $                                          | 7,769      |   | $ | 6,025 |   | $ | 1,682 |   | $ | — |   | $ | 15,476 |   |
| Cost  of revenue               |   | 3,442                                      |       | 1,466 |   | 548 |   | — |   | 5,456 |   |
| Gross  margin                  |   | 4,327                                      |       | 4,559 |   | 1,134 |   | — |   | 10,020 |   |
| Sales  and marketing           |   | 2,998                                      |       | 3,400 |   | 1,267 |   | — |   | 7,665 |   |
| Research  and development      |   | 2,088                                      |       | 1,619 |   | 452 |   | — |   | 4,159 |   |
| General  and administrative    |   | 1,267                                      |       | 982 |   | 274 |   | — |   | 2,523 |   |
| Other                          |   | —                                     |       | — |   | — |   | 2,114 |   | 2,114 |   |
| Total  operating expenses      |   | 6,353                                      |       | 6,001 |   | 1,993 |   | 2,114 |   | 16,461 |   |
| Loss  from operations          |   | $                                          | (2,026     | ) | $ | (1,442 | ) | $ | (859 | ) | $ | (2,114 | ) | $ | (6,441 | ) |
|                           |   |                                       |       |   |   |   |   |   |   |   |   |
|                           |   | **Six Months Ended April 30, 2003**   | ** ** |
|                           |   | **Americas**                               |       | **EMEA** | ** ** | **Asia** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                           |   |                                       |       |   |   |   |   |   |   |   |   |
| Revenue                        |   | $                                          | 13,974     |   | $ | 9,545 |   | $ | 2,980 |   | $ | 8,410 |   | $ | 34,909 |   |
| Cost  of revenue               |   | 2,716                                      |       | 2,120 |   | 539 |   | 2,650 |   | 8,025 |   |
| Gross  margin                  |   | 11,258                                     |       | 7,425 |   | 2,441 |   | 5,760 |   | 26,884 |   |
| Sales  and marketing           |   | 5,010                                      |       | 5,704 |   | 1,767 |   | 10 |   | 12,491 |   |
| Research  and development      |   | 2,722                                      |       | 1,859 |   | 580 |   | 31 |   | 5,192 |   |
| General  and administrative    |   | 1,633                                      |       | 1,115 |   | 345 |   | 19 |   | 3,112 |   |
| Other                          |   | —                                     |       | — |   | — |   | 1,902 |   | 1,902 |   |
| Total  operating expenses      |   | 9,365                                      |       | 8,678 |   | 2,692 |   | 1,962 |   | 22,697 |   |
| Income  (loss) from operations |   | $                                          | 1,893      |   | $ | (1,253 | ) | $ | (251 | ) | $ | 3,798 |   | $ | 4,187 |   |

 

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|                        |   | **Six Months Ended April 30, 2002** | ** ** |
|-----------------------------|--------|------------------------------------------|------------|
|                        |   | **Americas**                             |       | **EMEA** | ** ** | **Asia** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|                        |   |                                     |       |   |   |   |   |   |   |   |   |
| Revenue                     |   | $                                        | 16,827     |   | $ | 13,030 |   | $ | 3,532 |   | $ | — |   | $ | 33,389 |   |
| Cost  of revenue            |   | 7,412                                    |       | 2,907 |   | 817 |   | — |   | 11,136 |   |
| Gross  margin               |   | 9,415                                    |       | 10,123 |   | 2,715 |   | — |   | 22,253 |   |
| Sales  and marketing        |   | 6,984                                    |       | 6,567 |   | 2,485 |   | — |   | 16,036 |   |
| Research  and development   |   | 4,802                                    |       | 3,718 |   | 1,006 |   | — |   | 9,526 |   |
| General  and administrative |   | 2,518                                    |       | 2,047 |   | 556 |   | — |   | 5,121 |   |
| Other                       |   | —                                   |       | — |   | — |   | 8,925 |   | 8,925 |   |
| Total  operating expenses   |   | 14,304                                   |       | 12,332 |   | 4,047 |   | 8,925 |   | 39,608 |   |
| Loss  from operations       |   | $                                        | (4,889     | ) | $ | (2,209 | ) | $ | (1,332 | ) | $ | (8,925 | ) | $ | (17,355 | ) |

 

Long-lived assets, whichinclude property and equipment as well as intangible assets, by locationconsists of the following as of April 30, 2003 and October 31, 2002(in thousands):

 
|                     |   | **April 30,  2003** |   | **October 31,  2002** |   |
|--------------------------|--------|--------------------------|--------|----------------------------|--------|
| Long-lived  assets:      |   |                     |   |                       |   |
| United  States           |   | $                        | 10,890 |                       | $      | 12,866 |   |
| International            |   | 363                      |   | 413                        |   |
| Total  long-lived assets |   | $                        | 11,253 |                       | $      | 13,279 |   |

 

**(13) SUBSEQUENT EVENT**

 

Underthe terms of an Asset Acquisition Agreement dated June 6, 2003, theCompany acquired substantially all of the assets of Vultus, Inc., a corporationengaged in the web services interface business, in exchange for the issuance of167,590 shares of the Company’s restricted common stock and the assumption ofapproximately $207,000 in accrued liabilities of Vultus.  In addition, the Company assumed theobligations of Vultus under two secured notes payable to Canopy.  In connection with this assumption, Canopyagreed to accept the issuance of a maximum of 137,000 shares of the Company’srestricted common stock in full satisfaction of the obligations represented bythe assumed notes.  The number of sharesto be issued to Canopy in satisfaction of these obligations will be reduced tothe extent that an independent fairness evaluation of the acquired assets obtainedby the Company is less than $2,700,000. As discussed in Note 10, Canopy is the Company’s principal stockholderand was the majority stockholder in Vultus. The Company extended employment offers to most of the former employeesof Vultus.

 

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

 

The following discussionshould be read in conjunction with our condensed consolidated financialstatements and notes thereto, included elsewhere in this quarterly filing andour annual report on Form 10-K for the year ended October 31, 2002 filedwith the Securities and Exchange Commission, including the audited financialstatements and management’s discussion and analysis contained therein.  This discussion contains forward-lookingstatements that involve risks and uncertainties often indicated by such wordsas “estimates”, “anticipates”, “continue”, “expects”, “intends”, “believes” andsimilar expressions.  Our actual resultscould differ materially from those anticipated in these forward-lookingstatements as a result of various factors, including those set forth belowunder “Risk Factors” and elsewhere in this quarterly filing.

 

**Overview**

 

We originallyincorporated as Caldera Systems, Inc. (“Caldera Systems”), a Utah corporationon August 21, 1998, and reincorporated as a Delaware corporation onMarch 6, 2000.  In March 2000,we completed an initial public offering of our common stock.  On May 7, 2001, we formed a new holdingcompany under the name of Caldera International, Inc., (“Caldera”) to acquiresubstantially all of the assets and operations of the server and professionalservices groups of Tarantella Inc., formerly known as The Santa Cruz Operation,Inc., pursuant to an Agreement and Plan of Reorganization, dated August 1,2000 as subsequently amended.  Inconnection with this acquisition, Caldera Systems became a wholly-ownedsubsidiary of Caldera.  Formerholders of shares and options to purchase shares of Caldera Systems received anequal number of shares and options to purchase shares in Caldera.

 

OnMay 16, 2003, our shareholders approved our corporate name change to TheSCO Group, Inc. (“SCO” or the “Company”). We adopted this name change in response to the continuing brandrecognition related to the SCO OpenServer and SCO UNIXWare product lines.  As used herein, the “Company” or “us,” “we,”“ours,” or similar terms refer to The SCO Group, Inc. and our operating subsidiaries.

 

**Recent Developments**

 

During recent quarters,we have experienced a decline in our product and services revenue primarilyattributed to the worldwide economic slowdown, lower information technologyspending and increased competition in the operating system market.  However, we have implemented cost reductionmeasures to decrease personnel and excess facilities and have significantlyreduced our overall operating expenses. These measures, combined with the revenue from our SCOsource licensinginitiative, have resulted in the first profitable quarter in our history.

 

Over 95 percent of ourrevenue has been derived from UNIX related products and services.  During the quarter ended April 30,2003, we recognized $8,250,000,or 39 percent of our quarterly revenue, from our intellectual propertylicensing initiative, SCOsource, launched in January 2003.

 

One of the assets weacquired from Tarantella was the intellectual property rights to UNIX.  These rights had initially been developed byAT&T Bell Labs and over 30,000 licensing and sublicensing agreements havebeen entered into with approximately 6,000 entities.  These licenses led to the development of several proprietaryUNIX-based operating systems, including our own SCO UnixWare and SCOOpenServer, Sun’s Solaris, IBM’s AIX, SGI’s IRIX, HP’s UX, Fujitsu’s ICLDRS/NX, Siemens’ SINIX, Data General’s DG-UX, and Sequent’s DYNIX/Ptx.  We believe these operating systems are allderivatives of the original UNIX source code owned by us.

 

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We initiated theSCOsource effort to review the status of these 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 April 30, 2003 quarter.  The first of these licenses was with along-time licensee of the UNIX source code which is a major participant in theUNIX industry and was a “clean-up” license to cover items that were outside thescope of the initial license.  Thesecond license was to Microsoft Corporation (“Microsoft”), and coversMicrosoft’s UNIX compatibility products, subject to certain specifiedlimitations.  These license agreementswill be typical of those we expect to enter into with developers,manufacturers, and distributors of operating systems in that they arenon-exclusive, perpetual, royalty-free, paid up licenses to utilize the UNIXsource code, including the right to sublicense that code.

 

The amount that wereceive from any such licensee will generally depend on the license rights thatthe licensee previously held and the amount and level of our intellectualproperty the licensee desires to license. The two licensing agreements signed by us to date resulted in revenue of$8,250,000 during the April 30, 2003 quarter and provide for an aggregateof an additional $5,000,000 to be paid to us over the next three quarters.  These contracts do not provide for any paymentsbeyond 2003, except that Microsoft was granted the option to acquire expandedlicensing rights, at its election, that would result in additional payments tous if exercised.  In connection with theexecution of the first license agreement, we granted a warrant to the licenseeto purchase up to 210,000 shares of our common stock, for a period of fiveyears, at a price of $1.83 per share. This warrant has been valued, using the Black-Scholes valuation method,at $500,000.  Because the warrant wasissued for no consideration, $500,000 of the license proceeds have beenrecorded as warrant outstanding and the license revenue reduced accordingly.

 

During the course of thereview of our intellectual property rights, we became concerned generally aboutthe existence of UNIX source code in the Linux operating system.  We have discovered that UNIX source code andunauthorized derivatives of UNIX source code are prevalent in the Linuxkernel.  In March 2003, we filed acomplaint against IBM alleging, in part, that it had breached its licenseagreement with us by, among other things, inappropriately contributing UNIXsource code to the open source community and seeking to use its knowledge andmethods with respect to UNIX source code and derivative works and modificationslicensed to it to destroy the value of the UNIX operating system in favor ofpromoting the adoption by businesses of the Linux operating system, of which ithas been a major backer.  Unless IBMcures the breaches we have identified, we will terminate the license agreementwe have with it that permitted the use of our UNIX source code in thedevelopment of its AIX operating system. In May, 2003, we sent letters to approximately 1,500 large corporationsnotifying them that the use of the Linux operating system may be a violation ofour intellectual property rights.

 

The success of ourSCOsource licensing initiative, at least initially, will depend to a greatextent on the perceived strength of our intellectual property and contractualclaims and our willingness to enforce our rights.  Many, particularly those in the open source community, disputethe allegations of infringement that we have made.

 

While our SCOsourceinitiative has already resulted in significant revenue during theApril 30, 2003 quarter and we continue negotiations with other industryparticipants that we believe will lead to additional contracts, as a result ofthe factors outlined above, we are unable to predict the level or timing offuture revenue from this source, if any.

 

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THREE AND SIX MONTHSENDED APRIL 30, 2003 AND 2002

 

*Revenue*

 

Revenue was $21,369,000 for the second quarter of fiscal year 2003, and$15,476,000 for the second quarter of fiscal year 2002, representing anincrease of $5,893,000, or 38 percent.  This increase was attributable to $8,250,000in licensing revenue, which we generated for the first time, offset by adecline in product revenue of $1,484,000 and a decline in services revenue of$873,000.  Revenue was $34,909,000 for the first two quartersof fiscal year 2003, and $33,389,000 for the first two quarters of fiscal year2002, representing an increase of $1,520,000, or 5 percent.  This increasewas attributable to $8,250,000 in licensing revenue, offset by a decline inproduct revenue of $5,300,000 and a decline in services revenue of $1,430,000.

 

As discussed above in Recent Developments,we are unable to predict the level of licensing revenue we may recognize infuture periods.  During the first twoquarters of fiscal year 2003, our product and service revenue continues 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.  Excluding licensing revenue from SCOsource, revenue frominternational customers accounted for 48percent of operating system platform revenue for the second quarter of fiscalyear 2003 and 50 percent for thesecond quarter of fiscal year 2002, and revenue from international customersaccounted for 47 percent ofoperating system platform revenue for the first two quarters of fiscal year2003 and 50 percent for thefirst two quarters of fiscal year 2002. The decrease in international revenue for the second quarter and firsttwo quarters of fiscal year 2003 compared to the second quarter and first twoquarters of fiscal year 2002 is primarily attributable to decreased revenue inour Europe, Middle East and Africa (“EMEA”) region.

 

*Products.*  Products revenue was $11,122,000 for thesecond quarter of fiscal year 2003 and $12,606,000 for the second quarter offiscal year 2002, representing a decrease of $1,484,000, or 12 percent, and representing a slightincrease in products revenue from our first quarter of fiscal year 2003.  Products revenue was $22,212,000 for thefirst two quarters of fiscal year 2003 and $27,512,000 for the first twoquarters of fiscal year 2002, representing a decrease of $5,300,000, or 19 percent.

 

The decrease in productsrevenue during the second quarter of fiscal year 2003 from the second quarterof fiscal year 2002 as well as during the first two quarters of fiscal year2003 from the first two quarters of fiscal year 2002 was attributable to decreased sales of OpenServer and UnixWareproducts primarily resulting from a decrease in information technology spendingcaused by the worldwide economic slowdown.**** This impact was largely felt in ourdistribution channel in the Americas and Europe.  Our UNIX-based products revenue has also declined due toincreased competition in the operating system market from other softwareofferings.

 

OpenServer and UnixWareproducts are the largest components of the Company’s products revenue.  For the second quarter of fiscal year 2003,OpenServer revenue was $5,750,000**,** or 52 percent of total products revenue and UnixWare revenue was $3,017,000**,**or 27 percent of total productsrevenue.  For the first two quarters offiscal year 2003, OpenServer revenue was $10,491,000**,** or 47 percent of total products revenueand UnixWare revenue was $7,181,000**,** or 32 percent of total products revenue.

 

*Licensing*.  Licensing revenue was $8,250,000 for thesecond quarter and first two quarters of fiscal year 2003 as compared to norevenue for the second quarter and first two quarters of fiscal year 2002.  This revenue is the result of ourintellectual property licensing program, SCOsource, launched inJanuary 2003.  We initiatedSCOsource for the purpose of protecting the significant intellectual propertyrights we own surrounding the UNIX source code.  The licensing 

 

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revenue in the secondquarter of fiscal year 2003 represents a portion of the fees associated withtwo licenses executed during the quarter. Under the terms of one of these agreements, we will receive anadditional $5,000,000 over the next three quarters.  The agreements also grant the right to one of the licensees toacquire an expanded license upon the payment of additional fees.  We are in discussions with additionalpotential licensees, but are unable to predict the amount or timing of therevenue we might expect from this source in future periods.

 

*Services.*  Services revenue was $1,997,000 for thesecond quarter of fiscal year 2003 and $2,870,000 for the second quarter offiscal year 2002, representing a decrease of $873,000, or 30 percent.  Services revenue was $4,447,000 for the first two quarters offiscal year 2003 and $5,877,000 for the first two quarters of fiscal year 2002,representing a decrease of $1,430,000, or 24 percent.

 

The decrease in services revenue isprimarily related to the decrease in our products revenue as a portion of ourservices revenue is dependent on products revenue.  We have also experienced a decrease in our UNIX-related serviceofferings as a result of service offerings being bundled together withcompetitive operating system products, primarily Linux-related offerings.  We also experienced a decrease inprofessional services revenue as we have experienced a decrease in the demandfor custom enterprise-level projects.  Themajority of our support and professional services revenue continues to bederived from customers using UNIX-based operating systems.

 

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

### ** **

*Cost of ProductsRevenue.*  Cost of productsrevenue was $1,206,000 for the second quarter of fiscal year 2003 and$2,283,000 for the second quarter of fiscal year 2002, representing a decreaseof $1,077,000, or 47percent.  Cost of products revenue as apercentage of products revenue was 11percent for the second quarter of fiscal year 2003 and 18 percent for the second quarter of fiscal year 2002.  Cost of products revenue was $2,392,000 forthe first two quarters of fiscal year 2003 and $4,821,000 for the first twoquarters of fiscal year 2002, representing a decrease of $2,429,000, or 50 percent.  Cost of products revenue as a percentage of products revenue was 11 percent for the first two quartersof fiscal year 2003 and 18percent for the first two quarters of fiscal year 2002.

 

The decrease in the cost of productsrevenue as a percentage of revenue in the fiscal year 2003 periods compared tothe fiscal year 2002 periods was attributable primarily to reduced overhead andmanufacturing costs resulting from our cost containment efforts and decreasedroyalty obligations to third party vendors.  For the remainder of fiscal year 2003, weexpect the cost of products revenue as a percentage of products revenue to beconsistent with the first six months of fiscal year 2003.

 

*Cost of Licensing Revenue.*  Cost of licensing revenue was$2,163,000 for the second quarter and first two quarters of fiscal year 2003and $0 for the second quarter and first two quarters of fiscal year 2002.  Cost of licensing revenue as a percentage oflicensing revenue was 26 percent for the second quarter of fiscal year2003.  Cost of licensing revenueincludes the salaries and related personnel costs of internal personneldedicated to the SCOsource licensing initiative, as well as legal andprofessional fees incurred in connection with the execution of the licensing agreements.  We are unable to predict the percentage ofcost of licensing revenue for future quarters due to the unpredictability ofthe related licensing revenue.

 

*Cost of ServicesRevenue.*  Cost of servicesrevenue was $1,778,000 for the second quarter of fiscal year 2003 and$3,173,000 for the second quarter of fiscal year 2002, representing a decreaseof $1,395,000, or 44 percent.  Costof services revenue as a percentage of services revenue was 89 percent for thesecond quarter of fiscal year 2003 and 111 percent for the second quarter offiscal 

 

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year 2002.  Cost of services revenue was$3,470,000 for the first two quarters of fiscal year 2003 and $6,315,000 forthe first two quarters of fiscal year 2002, representing a decrease of$2,845,000, or 45 percent.  Costof services revenue as a percentage of services revenue was 78 percent for thefirst two quarters of fiscal year 2003 and 107 percent for the first twoquarters of fiscal year 2002.

 

The decrease in cost ofservices revenue as a percentage of services revenue in 2003 compared to 2002was attributable to decreased employee and related costs in our supportservices and professional services organization, decreased costs from externalprofessional services providers and from the elimination of certain third partysupport contracts.

 

For the remainder offiscal year 2003, we expect cost of services revenue as a percentage ofservices revenue to decline slightly from the first six months of fiscal year2003 as we begin to implement our web services strategy and focus additionalresources on generating services revenue.

 

### ***OperatingExpenses***

### ** **

*Sales andMarketing.*  Sales and marketingexpenses were $6,051,000 for the second quarter of fiscal year 2003 and$7,665,000 for the second quarter of fiscal year 2002, representing a decreaseof $1,614,000, or 21 percent.  Sales andmarketing expenses represented 28 percent of total revenue for the secondquarter of fiscal year 2003 down from 50 percent of total revenue for thesecond quarter of fiscal year 2002. Sales and marketing expenses were $12,491,000 for the first two quartersof fiscal year 2003 and $16,036,000 for the first two quarters of fiscal year2002, representing a decrease of $3,545,000, or 22 percent.  Sales and marketing expenses represented 36percent of total revenue for the first two quarters of fiscal year 2003 ascompared to 48 percent of total revenue for the first two quarters of fiscalyear 2002.

 

The decrease in thedollar amount of sales and marketing expense in the second quarter and firsttwo quarters of fiscal year 2003 compared to the second quarter and first twoquarters of fiscal year 2002 was attributable to fewer sales and marketingemployees, reduced travel expenses, less commissions and lower co-operativeadvertising costs as a result of lower revenue, and reduced communicationcosts.  We expect our sales andmarketing expenses for the last six months of fiscal year 2003 will decreaseslightly compared to the costs incurred in the first six months of fiscal year2003.

 

*Research andDevelopment.*  Research anddevelopment expenses were $2,542,000 for the second quarter of fiscal year 2003and $4,159,000 for the second quarter of fiscal year 2002, representing adecrease of $1,617,000, or 39 percent. Research and development costs represented 12 percent of total revenuefor the second quarter of fiscal year 2003 and 27 percent of total revenue forthe second quarter of fiscal year 2002. Research and development expenses were $5,192,000 for the first twoquarters of fiscal year 2003 and $9,526,000 for the first two quarters offiscal year 2002, representing a decrease of $4,334,000, or 45 percent.  Research and development costs represented15 percent of total revenue for the first two quarters of fiscal year 2003 and29 percent of total revenue for the first two quarters of fiscal year 2002.

 

The decrease in the dollar amount ofresearch and development expenses in the second quarter and first two quartersof fiscal year 2003 compared to the second quarter and first two quarters offiscal year 2002 was attributable to fewer employees, and reducedoutside consulting and contract services. These cost reductions were driven by consolidating development effortson core engineering projects related to our UNIX operating systems.  For the last six months of fiscal year 2003,we anticipate that our research and development expenses will remain consistentcompared to the costs incurred in the first six months of fiscal year 2003.

 

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*General andAdministrative.* General and administrative expenses were $1,462,000 for the secondquarter of fiscal year 2003 and $2,523,000 for the second quarter of fiscalyear 2002, representing a decrease of $1,061,000, or 42 percent.  General and administrative expensesrepresented 7 percent of total revenue for the second quarter of fiscal year2003 and 16 percent of total revenue for the second quarter of fiscal year 2002.  General and administrative expenses were$3,112,000 for the first two quarters of fiscal year 2003 and $5,121,000 forthe first two quarters of fiscal year 2002, representing a decrease of$2,009,000, or 39 percent.  General andadministrative expenses represented 9 percent of total revenue for the firsttwo quarters of fiscal year 2003 and 15 percent of total revenue for the firsttwo quarters of fiscal year 2002.

 

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

 

*Restructuring Charges. *During the second quarter of fiscal year 2003, werecorded a restructuring charge of $136,000. The restructuring charge for the second quarter of fiscal year 2003 wascomprised of $972,000 of severance and related payments offset by the reversalof $836,000 of previously recorded accruals related to leased facilities in theUnited Kingdom.  In connection withprior restructuring plans, we vacated certain facilities and accrued theestimated future lease costs.  As ofApril 30, 2003, the Company has been released from the future lease costs,and accordingly, the prior accruals were reversed.  During the second quarter of fiscal year 2002, we did not have arestructuring charge.

 

During the first twoquarters of fiscal year 2003, we recorded a net restructuring charge of($116,000).  The net restructuringcharge for the first two quarters of fiscal year 2003 was comprised of theamounts discussed above related to our UK subsidiary and additional adjustmentsto previously recorded restructuring charges for actual payments made.  During the first two quarters of fiscal year2002, we recorded a restructuring charge of $4,336,000 for costs incurred for theelimination of certain positions and the closure of certain facilities.

 

*Amortization of Intangibles. *Werecorded $700,000 for the amortization of intangibles in the second quarter offiscal year 2003 and $695,000 during the second quarter of fiscal year2002.  We recorded $1,400,000 for theamortization of intangibles in the first two quarters of fiscal year 2003 and$1,451,000 during the first two quarters of fiscal year 2002.  This amortization expense is for intangibleassets we acquired in connection with the acquisition of technology and otherassets from Tarantella and technology from Acrylis, Inc.

 

*Write-downof Investment. *During the second quarter and first twoquarters of fiscal year 2003, we did not have any write-down ofinvestments.  During the second quarter and first twoquarters of fiscal year 2002, we determined that the current carrying value ofour investment in Lineo, Inc. would not be realized and a write-down wasnecessary.  We recorded a write-down of$1,180,000 related to this investment.

 

*Stock-basedCompensation. *Inconnection with stock options and restricted shares granted to employees andothers, we recorded stock-based compensation of $406,000 in the second quarterof fiscal year 2003 and $239,000 for the second quarter of fiscal year2002.  We recorded stock-basedcompensation of $618,000 in the first two quarters of fiscal year 2003 and$630,000 for the first two quarters of fiscal year 2002.

 

The increase instock-based compensation in the second quarter of fiscal year 2003 isattributable to restricted stock grants made in previous quarters, whereby thefair value of the 

 

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restricted stock awardsis amortized as a component of stock-based compensation as the restrictionslapse.

 

*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 second quarter of fiscal year 2003, we recognized a net lossof $75,000 that represented our portion of Vista’s net loss.  For the first two quarters of fiscal year2003, we recognized $100,000 that represented our portion of Vista’s netloss.  We did not have an investment inVista during the 2002 periods.

 

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

### ** **

Other income (expense), net, which consistsprincipally of interest expense, interest income and other income, was($48,000) for the second quarter of fiscal year 2003 and ($135,000) for thesecond quarter of fiscal year 2002. Other expense was ($4,000) for the first two quarters of fiscal year2003 and ($65,000) for the first two quarters of fiscal year 2002.

 

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

### ** **

The provision for income taxes was $302,000for the second quarter of fiscal year 2003 and $55,000 for the second quarterof fiscal year 2002.  The provision forincome taxes was $307,000 for the first two quarters of fiscal year 2003 and$217,000 for the first two quarters of fiscal year 2002.  The provision for income taxes was primarilyrelated to earnings of foreign subsidiaries as well as federal alternativeminimum tax in the US and state income taxes for states in which the Companydoes not have sufficient net operating 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 first two quarters of 2003, our operations produced positivecash flow for the first time in our history. Although we believe that we will have sufficient financial resources tofund operations for the remainder of fiscal year 2003, however, if we areunable to continue to generate positive cash from operations we will not beable to implement our business plan without additional funding, which may notbe available to us.

 

As of April 30,2003, we had cash and cash equivalents of $10,015,000 and working capital of$1,454,000, which includes $9,218,000 of deferred revenue which will notrequire dollar for dollar of cash to settle, but will be recognized as revenuein future periods.  Our total cash andcash equivalents increased by $3,426,000 from October 31, 2002.  This increase resulted primarily from cashprovided by SCOsource licensing revenue. Additionally, the Company has a $2,910,000 line of credit from acommercial bank that bears interest at the prime rate minus one percent (with afloor rate of 3.75 percent) that matures on October 31, 2003.  Borrowings under the line of credit aresecured by a letter of credit from the Company’s principal stockholder.  As of April 30, 2003, there were noborrowings outstanding under the line of credit.

 

Our net cash provided byoperations during the six months ended April 30, 2003 was $3,839,000.  Cash provided by operations was primarilyattributable to net income of $3,776,000. Non-cash expenses totaled $2,891,000 and cash used by changes inoperating assets and liabilities was $2,828,000.  Our working capital position has increased from a deficit of$6,332,000 as of 

 

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October 31, 2002 toa positive $1,454,000 as of April 30, 2003, and our long-term liabilitieshave decreased from $1,625,000 to $618,000 during that same period.

 

Our investing activitieshave historically consisted of equipment purchases, investing in strategicpartners and the purchase and sale of available-for-sale securities.  During the six months ended April 30,2003, cash used in investing activities was $1,444,000, which was primarily aresult of equipment purchases of $328,000 and our investment in Vista of $450,000and cash paid to wind down our United Kingdom subsidiary of $666,000.

 

Our financing activitiesprovided $782,000 during the six months ended April 30, 2003 and consistedof proceeds received from the exercise of stock options and the purchase ofshares of common stock by our employees through our employee stock purchaseprogram and the issuance of a warrant.

 

Our net accountsreceivable balance increased slightly from $8,622,000 as of October 31,2002 to $8,793,000 as of April 30, 2003. The allowance for doubtful accounts was $324,000 as of April 30,2003, which represented approximately three percent of our gross accountsreceivable balance.  Our write-offs ofuncollectible accounts have not been material.

 

We generate revenue inCentral and South America. Historically, revenue and expenses in this region have not beensignificant.  In recent quarters, theeconomies of the countries of this region, Argentina in particular, haveexperienced significant volatility.  Wehave reviewed our sales to customers and our accounts receivable from customersin this region and have established reserves for potential bad debts as webelieve appropriate.  We believe ouroverall exposure related to transactions in this region is not material.

 

Wehave entered into operating leases for our corporate offices located in theUnited States and our international sales offices.  We have commitments under these leases that extend through fiscal2005.  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, there can be no assurance that we will be successful ineliminating or reducing cash expenditures for these leases.

 

Thefollowing table summarizes our contractual lease obligations as ofApril 30, 2003 (in thousands):

 
|                 |   | **Operating  Leases** |   |
|----------------------|--------|-----------------------|--------|
|                 |   |                  |   |
| Less  than one year  |   | $                     | 1,734  |   |
| One  to three years  |   | 4,856                 |   |
| Three  or more years |   | 600                   |   |
| Total  payments      |   | $                     | 7,190  |   |

 

We do not engage in anyoff balance sheet financing arrangements.

 

CRITICALACCOUNTING POLICIES

 

Ourcritical accounting policies include the following:

 

•                              Revenuerecognition;

 

•                              Incometaxes and related valuation allowances;

 

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•                              Impairmentof long-lived assets; and

 

•                              Allowancesfor doubtful accounts and product returns.

 

We recognize revenue inaccordance with Statement of Accounting Position (“SOP”) 97-2, as amended, andStaff Accounting Bulletin (“SAB”) 101. Revenue recognition in accordance with these pronouncements can becomplex due to the nature and variability of our sales transactions.  We recognize 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 andundelivered products, maintenance and other services), we allocate revenue toeach component of the contract based on objective evidence of its fair value,which is specific to us.  The fair valueof each element is based on amounts charged when such elements are soldseparately.  We recognize revenueallocated to undelivered products when the criteria for product revenue setforth above have been met.

 

Our SCOsource licensingrevenue to date has been generated from license agreements that arenon-exclusive, perpetual, royalty-free, paid up licenses to utilize our UNIXsource code, including the right to sublicense.  We recognize revenue from licensing agreements when a signedcontract exists, the fee is fixed and determinable, collection of thereceivable is probable and delivery has occurred.  If the payment terms extend beyond our normal payment terms, thenrevenue is recognized as cash is received.

 

We recognize revenue frommaintenance fees for ongoing customer support and product updates ratably overthe period of the maintenance contract. Payments for maintenance fees are generally made in advance and arenon-refundable.  For revenue allocatedto education and consulting services or derived from the separate sale of suchservices, we recognize revenue as the related services are performed.  We recognize product revenue from royaltypayments upon receipt of quarterly royalty reports from OEMs related to theirproduct sales.

 

Further implementationguidelines relating to SOP 97-2 and related modifications may result inunanticipated changes in our revenue recognition practices and such changescould significantly affect our future revenue and results of operations.

 

We have provided avaluation allowance of $48,644,000 against our entire net deferred tax asset asof October 31, 2002.  The valuationallowance was recorded because of our history of net operating losses and theuncertainties regarding our future operating profitability and taxableincome.  Had different assumptions beenused regarding the valuation allowance and our net deferred tax asset, ourincome tax provision could have been materially different than that reported.

 

We review our long-livedassets for impairment when events or changes in circumstances indicate that thebook value of an asset may not be recoverable. We evaluate, at each balance sheet date, whether events andcircumstances have occurred which indicate possible impairment.  The carrying value of a long-lived asset isconsidered impaired when the anticipated cumulative undiscounted cash flows ofthe related asset or group of assets is less than the carrying value.  In that event, a loss is recognized based onthe amount by which the carrying value exceeds the estimated fair market valueof the long-lived asset.

 

We performed a valuationof our intangible assets as of October 31, 2002 in accordance with SFASNo. 142, “Goodwill and Other Intangible Assets” and determined that theintangible assets reported in the accompanying consolidated balance sheets arenot impaired.  Write-downs 

 

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of intangible assets maybe necessary if the future fair value of these assets is less than carryingvalue.

 

Weoffer credit terms on the sale of our products to a significant majority of ourcustomers and require no collateral from these customers.  We perform ongoing credit evaluations of ourcustomers’ financial condition and maintain an allowance for doubtful accountsreceivable based upon our historical collection experience and expectedcollectibility of all accounts receivable. We also maintain an allowance for estimated returns based on ourhistorical experience.  Our actual baddebts and returns may differ from our estimates and the differences may bematerial.

 

RECENTACCOUNTING PRONOUNCEMENTS

 

In May 2003, FASBissued SFAS No. 150, "Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity"*. *SFAS No. 150establishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity.  Financial instruments within the scope ofSFAS No. 150 will be classified as liabilities and measured at fair value.  Many of those instruments were previouslyclassified as equity.  The statement iseffective for financial instruments entered into or modified after May 31,2003, and otherwise effective at the beginning of the first interim periodbeginning after June 15, 2003.  Theadoption of SFAS No. 150 is not expected to have an impact on our financialposition or results of operations.

 

ITEM3.                                   QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

FOREIGNCURRENCY RISK

 

Wehave foreign offices and operations primarily in Europe and Asia.  As a result, a substantial portion of ourrevenue is derived from sales to customers outside the United States.  Most of this international revenue isdenominated in U.S. dollars.  However,most of the operating expenses related to the foreign-based operations aredenominated in foreign currencies and therefore operating results are affectedby changes in the U.S. dollar exchange rate in relation to foreign currenciessuch as the Euro, among others.  If theU.S. dollar were to weaken compared to the Euro, our operating expenses offoreign operations will be higher when translated back into U.S. dollars andadditional funds may be required to meet these obligations.  Our revenue can also be affected by generaleconomic conditions in the United States, Europe and other internationalmarkets.  Our results of operations maybe affected in the short term by fluctuations in foreign currency exchangerates.  Historically, these amounts havenot been significant.

 

INTERESTRATE RISK

 

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

 

INVESTMENTRISK

 

Wehave invested in equity instruments of privately held and public companies inthe high-technology industry for business and strategic purposes.  Investments are accounted for under the costmethod if our ownership is less than 20 percent and we are not able to exerciseinfluence over operations.  Ourinvestment policy is to regularly review the assumptions and operatingperformance of these companies and to record impairment losses when events andcircumstances indicate that these investments may be impaired.  As of April 30, 2003, our investmentsbalance was approximately $825,000.

 

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Thestock market in general, and the market for shares of technology companies inparticular, has experienced extreme price fluctuations.  In addition, factors such as new productintroductions by our competitors and us may have a significant impact on themarket price of our common stock.  Theseconditions could cause the price of our stock to fluctuate substantially overshort periods of time.

 

ITEM4.                                   CONTROLS AND PROCEDURES

 

(a)                                  Evaluation of Disclosure Controls andProcedures

 

OurChief Executive Officer and Chief Financial Officer have reviewed and evaluatedthe effectiveness of our disclosure controls and procedures (as defined inSecurities Exchange Act of 1934 Rules 13a-14(c)) as of a date within 90 daysbefore the filing date of this quarterly report on Form 10-Q.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that our disclosurecontrols and procedures are effective and timely in providing them withmaterial information required to be disclosed in the reports we file or submitunder the Securities Exchange Act of 1934.

 

(b)                                 Changes in Internal Controls

 

Therehave not been any significant changes in our internal controls or in otherfactors that could significantly affect these controls subsequent to the dateof their evaluation.  There were nosignificant deficiencies or material weaknesses, and therefore, no correctiveactions were taken.

 

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

#### *** ***

*We donot have a history of profitable operations.*

 

The April 30, 2003,quarter was our first quarter of profitability.  If we do not receive SCOsource licensing revenue in futurequarters and our revenue from the sale of our operating system platformproducts and services continues to decline, we will need to further reduceoperating expenses in order to maintain profitability or generate positive cashflow.  If we are unable to generatepositive cash flow from operations, we will not be able to implement ourbusiness plan without additional funding, which may not be available to us.

 

*Ourfuture SCOsource licensing revenue is uncertain.*

 

We initiated theSCOsource licensing effort in January 2003 to review the status of UNIXlicensing and sublicensing agreements and to identify others in the industrythat may be currently using our intellectual property without obtaining thenecessary licenses.  This effortresulted in the execution of two license agreements during the April 30, 2003quarter.  These two license agreementswill be typical of those we expect to enter into with developers,manufacturers, and distributors of operating systems in that they arenon-exclusive, perpetual, royalty-free, paid up licenses to utilize the UNIXsource code, including the right to sublicense that code.  Due to a lack of historical experience andthe uncertainties related to SCOsource licensing revenue, we are unable toestimate the amount and timing of future licensing revenue, if any.  If we do receive revenue from this source,it may be sporadic and fluctuate from quarter to quarter.  SCOsource licensing revenue is unlikely toproduce stable, predictable revenue for the foreseeable future.

 

*Our stock price is volatile.*

 

The trading price for ourcommon stock has been volatile, ranging from a low closing sales price of $1.09in mid February 2003, to recent highs in excess of $9.00 per share.  The share 

 

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price has changeddramatically over short periods with increases and decreases of over 25 percentin a single day.  We believe that thechanges in our stock price are affected by changing public perceptionsconcerning the strength of our intellectual property claims and other factorsbeyond our control.  Public perceptioncan change quickly and without any change or development in the underlyingfacts.  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 raiseadditional funds to expand our business, support operations, respond tocompetitive pressures, acquire complementary businesses or technologies orrespond to unanticipated requirements. We cannot assure you that additional funding will be available to us inamounts or on terms acceptable to us.

 

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

 

On March 6, 2003, wefiled a complaint against IBM alleging breach of contract, misappropriation oftrade secrets, tortious interference, and unfair competition.  The complaint centers on IBM’s activitiesregarding the UNIX operating system that underlies both our UNIX-basedoperating systems and IBM’s AIX, its UNIX-based operating system.  The complaint alleges that IBM obtainedinformation concerning the UNIX source code from us and inappropriately usedand distributed that information in connection with its efforts to promote theLinux operating system.  The complaintseeks damages in excess of $1 billion dollars.

 

We have provided IBMnotice that we will have the authority to revoke its UNIX license agreementthat underlies their AIX software on June 13, 2003, unless IBM cures theclaims that we have asserted.  Inaddition, we have publicly, and in individual letters to 1,500 of the largestcorporations, cautioned users of Linux that there are unresolved intellectualproperty issues surrounding Linux that may expose them to unanticipated liability.  As a result of these concerns, we havesuspended our sales of Linux products.

 

Pursuit of the litigationagainst IBM and, potentially, others will be costly, and we expect our costsfor legal fees could be substantial.  Inaddition, we may experience a decrease in revenue as a result of the loss ofsales of Linux products and initiatives previously undertaken jointly with IBMand others affiliated with IBM.  Weanticipate that participants in the Linux industry will seek to influenceparticipants in the markets in which we sell our products to reduce oreliminate the amount of our products and services that they purchase.  There is also a risk that the assertion ofour intellectual property rights will be negatively viewed by participants inour marketplace and we may lose support from such participants.  Any of the foregoing could adversely affectour position in the marketplace and our results of operations.

 

*If ourSCO branding effort is not accepted or causes market confusion, our businessmay be adversely affected.*

 

We recently launched arebranding effort for our products and services as well as our corporateimage.  On May 16, 2003, ourstockholders approved the change of our corporate name to The SCO Group, Inc.  Prior to our name change, we have renamedour UNIX products and services using the SCO trademark to draw on this strongbrand recognition.  We acquired therights to use this trademark in May 2001 from Tarantella in connectionwith our acquisition of certain Tarantella assets and operations.  If the rebranding effort is not accepted byour resellers or customers of our products and services, if the rebrandingefforts cause confusion, or if there are negative connotations associated withthe trademark that we cannot successfully address, our business may beadversely affected.

 

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*If ourrecently launched products and services are not accepted in the marketplace,our business may be adversely affected.*

 

In January 2003, weannounced SCOsource, our intellectual property licensing business and inApril 2003 announced SCOx, our web services strategy.  In addition, we have recently released newversions of our SCO OpenServer and SCO UNIXWare operating systems.  If our resellers or customers do not acceptthese initiatives or product enhancements, if the products fail to perform asexpected, or if revenue from these initiatives is below our expectations, ourbusiness may be adversely affected.

 

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

 

As a result of thefactors listed above and elsewhere, it is possible that our results ofoperations may be below the expectations of public market analysts andinvestors in any particular period.  Thiscould cause our stock price to decline. If revenue falls below our expectations and we are unable to quicklyreduce our spending in response, our operating results will be lower thanexpected.  Our stock price may fall inresponse to these events.

 

*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 

 

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through resellers, wecannot control the relationships through which solution providers or equipmentintegrators purchase our products.  Inturn, we do not control the presentation of our products to end-users.  Therefore, our sales could be affected bydisruptions in the relationships between us and our resellers, between ourresellers and electronic solution providers, or between electronic solutionproviders and end users.  Also,resellers and electronic solution providers may choose not to emphasize ourproducts to their customers.  Any ofthese occurrences could diminish the effectiveness of our distribution channeland lead to decreased sales.

 

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

 

Our revenue from the saleof UNIX based products has declined since we acquired these operations fromTarantella.  This decrease in revenuehas been attributable to the worldwide economic slowdown as well as fromcompetitive pressures from alternative operating systems.  If the demand for UNIX based productscontinues to decline, and we are unable to develop new products and servicesthat successfully address a market demand, our business will be adverselyaffected.

 

*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.  Thesecompetitors are aggressively pursuing the current UNIX operating system market.  Many of these competitors have access togreater resources that we do.  Morerecently, the major competitive alternative to our UNIX products is Microsoft’sNT and Linux.  While we believe that ourserver products retain a competitive advantage in a number of targetedapplication areas, the expansion of Microsoft’s and our other competitors’offerings may restrict the overall market available for our server products,including some markets where we 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 Southeast Asia.  These foreign operations are subject tocertain 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 in which 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 we generateconsolidated net losses.

 

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In Latin America andSoutheast Asia in particular, several countries have suffered and may beespecially susceptible to recessions and economic instability which may lead toincreased governmental ownership or regulation of the economy, higher interestrates, increased barriers to entry such as higher tariffs and taxes, andreduced demand for goods manufactured in the United States, resulting in lowerrevenue.

 

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

 

During the last severalquarters the U.S. and European economies have experienced an economic slowdownthat has affected the purchasing habits of many consumers across manyindustries and across many geographies. This has caused the delay, or even cancellation of technologypurchases.  The ultimate impact of theslowdown in the United States and Europe is difficult to predict, but it hasresulted in decreased sales of our products, longer sales cycles and lowerprices.  If the current slowdowncontinues, our revenue and results of operations may continue to be lower thanexpected.  In addition, the slowdown mayalso affect the end-user market making it more difficult for our resellerchannel to sell our products.

 

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

 

Certain holders of ourcommon stock have demand and piggyback registration rights obligating us toregister 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 ofany officers or key employees could harm our ability to implement our businessplan and could adversely affect our operations.  Our future success depends to a significant extent on thecontinued service and coordination of our management team, particularly DarlMcBride, our President and Chief Executive Officer.  We do not maintain key person insurance for any member of ourmanagement team.

 

PART II.                                                 OTHER INFORMATION

 

ITEM 1.                                   LEGAL PROCEEDINGS

 

On March 7, 2003, wefiled a complaint against IBM Corporation. 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,particularly UNIX on Intel, to benefit IBM’s Linux services business.  As a result of IBM’s breach of contract andunfair competition and the marketplace injury sustained by SCO, we arerequesting damages in an amount to be proven at trial, but no less than $1billion, together with additional damages through and after the time of trial.

 

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We have also demandedthat IBM cease these anti-competitive practices based on specific requirementssent in a notification letter to IBM. If these requirements are not met by June 13, 2003, we will havethe authority to revoke IBM’s AIX license.

 

IBM has filed itsresponse to the complaint, including a demand for jury trial, but there hasbeen no discovery to date.  IBM has alsoremoved the action from Utah Third District State Court to the Federal DistrictCourt for the District of Utah.  A copyof the proceedings is on file with the United States Federal District Court forthe District of Utah and can also be found at www.sco.com/scosource.

 

ITEM 2.                                   CHANGES IN SECURITIES AND USE OFPROCEEDS

 

During the quarterended April 30, 2003, the Company issued a warrant to one of the twoSCOsource licensees.  The warrant allowsthe licensee to acquire 210,000 shares of the Company’s common stock at anexercise price of $1.83 per share.  Theoption expires five years from the date of grant.  The Company has recorded the fair value of the warrant of$500,000, as determined using the Black-Scholes option-pricing model, as awarrant outstanding during the quarter ended April 30, 2003.  Assumptions used in the Black-Scholesoption-pricing model were the following: estimated fair value of common stockof $2.40 per share, risk free interest rate of three percent, volatility of 236percent, and expected dividend yield of 0 percent.  This warrant was issued pursuant to an exemption from theregistration requirements under Section 4(2) of the Securities Act of 1933, asamended.

 

ITEM 6.                                   EXHIBITS AND REPORTS ON FORM 8-K

 

(a)                                  Exhibits

 

3.1                                 Certificateof Amendment to Amended and Restated Certificate of Incorporation (incorporatedby reference to Appendix C to the Company’s definitive Proxy Statement)

 

99.1                           Certificationof Chief Executive Officer

 

99.2                           Certificationof Chief Financial Officer

 

(b)                                 Reports on Form 8-K

 

On March 7, 2003,the Company filed a current report on Form 8K disclosing that it had filed alaw suit against IBM.

 

ITEM 7.                                   SIGNATURES

 

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

 
| Date:  June 13, 2003 | THE SCO GROUP, INC. |
|--------------------------------|---------------------|
|                           |                |   |   |
|                           |                | By: | /s/ Robert K. Bench |   |
|                           |                |   | Robert K. Bench |
|                           |                |   | Chief Financial Officer |
|                           |                |   | (Principal Financial  Officer) |

 

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**CERTIFICATION****PURSUANT TO RULE 13A-14OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED,AS ADOPTED PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002**

 

 

I, Darl McBride, certifythat:

 

1.               Ihave reviewed this quarterly report on Form 10-Q of The SCO Group, Inc.;

 

2.               Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.               Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.               Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

(a)                                  designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

(b)                                 evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

(c)                                  presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.               Theregistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors:

 

(a)                                  allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)                                 anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.               Theregistrant’s other certifying officer and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent 

 

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evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 
| Date:  June 13, 2003.        |
|----------------------------------------|
|                                   |
|                                   |
| /s/ Darl McBride                       |   |
| Darl McBride                           |
| President and Chief  Executive Officer |

 

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**CERTIFICATIONPURSUANT TO RULE 13A-14OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED,AS ADOPTED PURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002**

 

 

I, Robert K. Bench,certify that:

 

1.               Ihave reviewed this quarterly report on Form 10-Q of The SCO Group, Inc.;

 

2.               Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterly report;

 

3.               Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.               Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

(a)                                  designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

(b)                                 evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

(c)                                  presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.               Theregistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors:

 

(a)                                  allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)                                 anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.               Theregistrant’s other certifying officer and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or in

 

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other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date:  June 13, 2003. |
|---------------------------------|
|                            |
|                            |
| /s/ Robert K. Bench             |   |
| Robert K. Bench                 |
| Chief Financial Officer         |

 

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