SECURITIES AND EXCHANGE COMMISSION

 

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark one)
ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended JANUARY 31, 2004
OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from            to

 

Commission file number 0-29911

 

THE SCO GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

355 South 520 West

Suite 100

Lindon, Utah 84042

(Address of principal executive offices and zip code)

 

(801) 765-4999

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for 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 the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

 

YES ý NO o

 

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

 

 

The SCO Group, Inc.

 

Table of Contents

 

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

 

2

 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, in thousands)

 

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

 

See notes to condensed consolidated financial statements.

 

3

 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(unaudited, in thousands, except per share data)

 

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

 

See notes to condensed consolidated financial statements.

 

4

 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands)

 

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

 

See notes to condensed consolidated financial statements.

 

5

 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

(1)   ORGANIZATION AND DESCRIPTION OF BUSINESS

 

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

 

On May 7, 2001, Caldera International, Inc. (“Caldera”) was formed as a holding company to own Caldera Systems and to acquire substantially all of the assets, liabilities and operations of the server and professional services groups of The Santa Cruz Operation, now known as Tarantella, Inc., pursuant to an Agreement and Plan of Reorganization (the “Reorganization Agreement”), dated as of August 1, 2000, as amended.  Under the Reorganization Agreement, Caldera acquired the tangible and intangible assets used in the server and professional services groups, including all of the capital stock of certain of The Santa Cruz Operation’s 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, were converted into the same number of shares of common stock of Caldera and options to purchase shares of common stock of Caldera.

 

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

 

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

 

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

 

(2)   SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) on a basis consistent with the Company’s audited annual financial statements, and, in the opinion of management, reflect all adjustments, consisting of normal recurring adjustments, necessary to present fairly the financial information set forth therein.  Certain information and footnote disclosures normally included in financial statements

 

6

 

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

 

Use of Estimates in the Preparation of Financial Statements

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.  Actual results could differ from these estimates.  The Company’s critical accounting policies and estimates, as discussed in the Company’s most recent annual report on Form 10-K, include, among others, revenue recognition, allowances for doubtful accounts receivable, determination of fair value of the derivative associated with the Company’s previously issued shares of redeemable Series A Convertible Preferred Stock, impairment of long-lived assets, and valuation allowances against deferred income tax assets.

 

Revenue Recognition

 

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

 

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

 

The majority of the Company’s revenue transactions relate to product-only sales.  On occasion, the Company has revenue transactions that have multiple elements (i.e., delivered and undelivered products, maintenance and other services).  For software agreements that have multiple elements, the Company allocates revenue to each component of the contract based on the relative fair value of the elements.  The fair value of each element is based on vendor specific objective evidence (“VSOE”).  VSOE is established when such elements are sold separately.  The Company recognizes revenue allocated to undelivered products when the criteria for product revenue recognition set forth above have been met.  If VSOE of all undelivered elements exists, but VSOE does not exist for one or more delivered elements, then revenue is recognized using the residual method.  Under the residual method, the fair value of the undelivered elements is deferred and recognized in future periods and the remaining portion of the license fee is recognized in the current period as product revenue.

 

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

 

7

 

The Company’s SCOsource licensing revenue to date has been generated from license agreements to utilize the Company’s UNIX source code as well as from intellectual property compliance licenses.  The Company recognizes revenue from SCOsource licensing 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 the Company’s normal payment terms, revenue is recognized as the payments are received.

 

Hedging of Foreign Currency Transactions

 

The Company utilizes foreign currency forward exchange contracts to hedge foreign currency market exposures of underlying assets and liabilities.  The Company does not use forward exchange contracts for speculative or trading purposes.  The Company’s accounting policies for these instruments are based on the Company’s designation of such instruments as hedging transactions.  The criteria the Company uses for designating an instrument as a hedge include the instrument’s effectiveness in risk reduction and one-to-one matching of forward exchange contracts to underlying transactions.  Gains and losses on currency forward contracts that are designated and effective as hedges of firm commitments are deferred and recognized in income in the same period that the underlying transactions are settled.  Gains and losses on currency forward contracts that are designated and effective as hedges of existing transactions are recognized in income in the same period as losses and gains on the underlying transactions are recognized and generally offset.  Gains and losses on any instruments not meeting the above criteria are recognized in income in the current period.  As of January 31, 2004, the Company had one foreign exchange contract with a maturity of approximately 30 days to sell an aggregate of 650,000 United Kingdom pounds for approximately $1,170,000 U.S. dollars.  As of January 31, 2004, the Company had no outstanding instruments accounted for as hedges.

 

Cash and Cash Equivalents and Available-for-Sale Securities

 

The Company considers all highly liquid debt instruments purchased with original maturities of three or fewer months to be cash equivalents.  Cash and cash equivalents were approximately $57,945,000 as of January 31, 2004, which primarily consisted of investments in money market funds and commercial paper.

 

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

 

 

 

 

8

 

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

 

 

Net Income (Loss) per Common Share

 

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

 

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

 

 

Pro Forma Fair Value of Stock-based Compensation

 

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

 

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

 

9

 

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

 

 

For purposes of the pro forma disclosure, the estimated fair value of the stock options, restricted stock awards and ESPP shares are amortized over the vesting period of the award.  The following is the pro forma disclosure and the related impact on net loss and the net loss per diluted common share for the three months ended January 31, 2004 and 2003 (in thousands, except per share amounts):

 

 

(3)   INTANGIBLE ASSETS

 

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

 

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

 

 

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

 

10

 

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

 

(4)   RESTRUCTURING PLANS

 

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

 

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

 

The remaining restructuring accrual relates to costs associated with one facility that has future lease payments extending through June 2005.

 

(5)   REDEEMABLE SERIES A CONVERTIBLE PREFERRED STOCK

 

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

 

The terms of the Series A include a number of redemption provisions that represent a derivative financial instrument under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  The Company determined that the conversion feature to allow the holders of the Series A to acquire common shares was an embedded derivative that does not qualify as a scope exemption under the provisions of EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock.”  This required the Company to record at fair value and mark-to-market the fair value of the derivative.  Changes in the fair value of the derivative are recorded in the Company’s statement of operations.  As of October 16, 2003, the Company, through the assistance of an independent valuation firm, determined the initial fair value of the derivative was $18,069,000.  As of October 31, 2003, the fair value of the derivative was $15,224,000 and the decrease in fair value of $2,845,000 was recorded as other income in the statement of operations for fiscal year 2003.

 

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

 

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

 

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12 percent per annum.  The Company has the option of paying dividends in cash or shares of the Series A, subject to certain limitations.  Because dividends are not payable during the first year the Series A is outstanding, the Company has accrued dividends of $756,000 for three months ended January 31, 2004, which reduced earnings to common stockholders.  These dividends are in addition to $123,000 in accrued dividends recorded in fiscal year 2003.

 

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

 

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

 

(6)   COMMITMENTS AND CONTINGENCIES

 

Litigation

 

IBM, Corporation

 

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

 

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

 

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

 

12

 

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

 

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

 

Red Hat, Inc.

 

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

 

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

 

Novell, Inc.

 

On or about January 20, 2004, the Company brought suit against Novell, Inc. for slander of title seeking relief for Novell’s alleged bad faith efforts to interfere with the Company’s copyrights related to its UNIX source code and derivative works and its UnixWare product.  In the lawsuit, the Company requested preliminary and permanent injunctive relief as well as damages.  The injunction would require Novell to assign to the Company all copyrights that it believes Novell has wrongfully registered, prevent Novell from representing any ownership interest in those copyrights and require Novell to retract or withdraw all representations it has made regarding its purported ownership of those copyrights.  Novell has not yet answered the Company’s complaint but has filed with the United States District Court for the District of Utah a notice removing the case to such federal court and a motion with the Third Judicial District Court in Salt Lake County, Utah to transfer the venue of the case from such court to the Fourth Judicial District Court in Utah County, Utah.  Neither court has ruled on these actions.   Novell also filed a motion to dismiss the Company’s complaint claiming it never transferred the copyrights to The Santa Cruz Operation.  The Company has filed a response to Novell’s motion to dismiss and has also filed a motion to remand the case back to the state court.  The court has not ruled on these motions.  The Company plans to vigorously pursue its claims against Novell.

 

IPO Matter

 

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

 

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settling the dispute between the plaintiffs and the issuers.  The Company has executed this MOU and has been advised that almost all (if not all) of the issuers have elected to proceed under the MOU.  The MOU is still subject to court approval and the preparation of appropriate settlement documents.  If the settlement is approved by the court and settlement agreements can be entered into by the parties, and if no cross-claims, counterclaims or third party claims are later asserted, this action will be dismissed with respect to the Company and its individuals.

 

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

 

Other Matters

 

In April 2003, a former Indian distributor of the Company filed a claim in India, requesting summary judgment for payment of $1,428,000, and an order that the Company trade in India only through the distributor until the claim is paid. The distributor claims that the Company is responsible to repurchase certain software products and to reimburse the distributor for certain other operating costs.  Management does not believe that the Company is responsible to reimburse the distributor for any operating costs and also believes that the return rights related to any remaining inventory have lapsed.  Management has engaged local counsel who has advised that it is likely that the current claims will fail, but that the distributor will continue to pursue its claims either in the Indian courts or in the U.S. courts.  Discovery has commenced and initial hearings have been held and are ongoing.  The Company intends to vigorously defend this action.

 

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

 

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

 

Arrangement with Law Firms

 

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

 

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

 

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

 

(7)   STOCKHOLDERS’ EQUITY

 

Stock-Based Compensation

 

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

 

 

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

 

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

 

Employee Stock Purchase Plan

 

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

 

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

 

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

 

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(8)   SIGNIFICANT CUSTOMERS

 

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

 

(9)   SEGMENT INFORMATION

 

The Company’s resources are allocated and operating results managed to the operating income (loss) level for each of the Company’s two geographic units for its UNIX division and the Company’s SCOsource licensing division.  The geographic units for the UNIX division consist of the Americas division and the International division.  The revenue, cost of revenue and direct sales and marketing expenses are tracked for each division.  The costs of corporate sales and marketing, research and development and general and administration are allocated to each division based on that divisions’ percentage of total revenue.  The corporate revenue and expenses include amounts not directly attributable to a specific division.

 

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

 

 

 

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

 

 

(10) SUBSEQUENT EVENTS

 

End User Lawsuits

 

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

 

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

 

Exchange Agreement with Series A Investors

 

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

 

The Company anticipates recording other income in the second quarter of fiscal year 2004 related to the change in the fair value of the Series A derivative between January 31, 2004 and February 5, 2004, the date on which the exchange agreement was executed.  The Company also anticipates recording a dividend

 

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

 

Stock Repurchase Program

 

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

 

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

 

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

 

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

 

Overview

 

Historical Background.  We originally incorporated as Caldera Systems, Inc., a Utah corporation (“Caldera Systems”), on August 21, 1998, and reincorporated as a Delaware corporation on March 6, 2000.  In March 2000, we completed an initial public offering of our common stock.  On May 7, 2001, we formed a new holding company in Delaware under the name of Caldera International, Inc. to acquire substantially all of the assets and operations of the server and professional services groups of The Santa Cruz Operation (now known as Tarantella, Inc.).  In connection with this acquisition, Caldera Systems became a wholly-owned subsidiary of Caldera International, Inc.  Former holders of shares and options to purchase shares of Caldera Systems received an equal number of shares and options to purchase shares in Caldera International, Inc.  On May 16, 2003, our stockholders approved our corporate name change to The SCO Group, Inc.

 

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

 

We anticipate recording other income in the second quarter of fiscal year 2004 related to the change in the fair value of the derivative between January 31, 2004 and February 5, 2004, the effective date of our exchange transaction.  We also anticipate recording a dividend in the second quarter of fiscal year 2004, related to the difference between the fair value of the new redeemable Series A-1 Convertible Preferred Stock and the carrying value of the previously issued redeemable Series A Convertible Preferred Stock and related derivative.  This dividend will reduce earnings to common stockholders.

 

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

 

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

 

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

 

On March 10, 2004, our board of directors authorized management, in its discretion, to purchase up to 1,500,000 shares of our common stock over a 24-month period.  Shares may be purchased in open market transactions, block purchases or privately negotiated transactions.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.

 

Business Focus

 

We generate revenue primarily from two sources: product and services revenue from our UNIX operating systems business and license fees from our SCOsource licensing business.

 

UNIX Business.  Our UNIX business serves the needs of small-to-medium sized businesses, including replicated site franchisees of Fortune 1000 companies, by providing reliable, cost effective UNIX operating systems and software products to power computers running on Intel architecture.  Our largest source of UNIX business revenue is derived from our worldwide, indirect, leveraged channel of partners, which includes distributors and independent solution providers.  We have local offices in a number of countries that provide support and services to

 

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customers and resellers in that geographic area.  The other principal channel for selling and marketing our UNIX products is through major corporations that have a large number of replicated sites or franchisees.  We access these corporations through their information technology or purchasing departments with our Area Sales Managers in the United States and through our reseller channel in countries outside the United States.  In addition, we also sell our operating system products to OEMs.  Until fiscal year 2003, the majority of our revenue and our operating expenses were derived from our UNIX business.

 

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

 

The decline in our UNIX business revenue may be accelerated if industry partners withdraw their support as a result of our SCOsource initiatives and in particular any lawsuits against end users violating our intellectual property and contractual rights.  Our SCOsource initiatives, particularly lawsuits against such end users, may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products.  This would lead to an accelerated decline in our UNIX products and services revenue.

 

In an effort to offset this decrease in UNIX revenue, we have decreased our operating costs and increased our gross margin percentage over the last three fiscal years.  Operating costs decreased from $11,400,000 for the three months ended January 31, 2003 to $10,911,000 for the three months ended January 31, 2004.  We have reduced the number of employees from 339 as of January 31, 2003 to 303 as of January 31, 2004, eliminated redundant facilities and reduced other discretionary spending while still preserving our worldwide infrastructure.  Our gross margin percentage from our UNIX business increased from 79 percent for the three months ended January 31, 2003, to 81 percent for the three months ended January 31, 2004.  We have accomplished this by reducing excess manufacturing and overhead costs, reducing our third-party royalty and technology costs and decreasing the number of employees in our services organization.

 

An important initiative for our UNIX business for our 2004 fiscal year will be continuing to maintain the level of investment in and commitment to our UNIX operating systems.  As part of this initiative, we intend to continue to invest in research and development efforts for our UNIX division for fiscal year 2004 to provide our OpenServer and UnixWare products with increased system reliability, maintain backward compatibility with existing applications and software, provide increased application support, provide additional hardware support, integrate widely used internet applications and increase system performance.  These enhancements will not have a direct impact on our short-term UNIX revenue because of the long adoption cycle for new operating system purchases and our long operating system product sales cycle.

 

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

 

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To offset the decline in our UNIX business and review the status of our UNIX licensing and sublicensing agreements, we initiated our SCOsource licensing initiatives in January 2003.  These initiatives now include, among others, seeking to enter into license agreements with UNIX vendors and implementing a worldwide program offering SCOsource intellectual property (“IP”) licenses to Linux end users allowing them to continue to use our UNIX source code and derivative works found in Linux.  Our SCOsource efforts resulted in the execution of two significant vendor license agreements during fiscal year 2003.  In fiscal year 2004, we plan to increase our SCOsource sales team as we continue to implement our SCOsource licensing strategies.

 

Our future success with our SCOsource initiatives and future revenue from SCOsource licenses will depend on our ability to protect our UNIX intellectual property.  We will continue to devote resources to our SCOsource initiatives, and we generally expect quarterly legal fees and other SCOsource related costs for the remaining quarters of fiscal year 2004 will be consistent with the level of costs incurred in the first quarter of fiscal year 2004,.  However, legal expenses could increase over time depending on developments in the litigation involving us, and certain events may take place that could require us to pay a 20 percent contingency fee to our law firms.  These events may include settlements, judgments, licensing fees, subject to certain exceptions, and a sale of our company during the pendancy of litigation or through settlement, subject to agreed upon credits for amounts received as discounted hourly fees and unused retainer fees.  Additionally, our agreement with our law firms may also be construed to include contingency fee payments in connection with any issuance of our equity securities.

 

Because of the uncertainties related to our SCOsource business, we are unable to estimate the amount and timing of future SCOsource licensing revenue.  This uncertainty represents a significant risk and challenge for us, both in the short and long term.  If we do receive revenue from this source, it may be sporadic and fluctuate from quarter to quarter.  Our SCOsource initiatives are unlikely to produce a stable or predictable revenue stream for the foreseeable future.  Additionally, the success of these initiatives may depend on the strength of our intellectual property rights and contractual claims regarding UNIX, including the strength of our claim that unauthorized UNIX source code and derivative works are prevalent in Linux.  We generated minimal SCOsource revenue in the first quarter of fiscal year 2004, but anticipate that revenue from vendor licenses and IP licenses will increase throughout the remainder of fiscal year 2004.

 

Critical Accounting Policies

 

Our critical accounting policies and estimates include the following:

 

•                                          Revenue recognition;

 

•                                          Deferred income taxes and related valuation allowances;

 

•                                          Fair value of derivative financial instrument;

 

•                                          Impairment of long-lived assets; and

 

•                                          Allowances for doubtful accounts.

 

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

 

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recognize product revenue from royalty payments upon receipt of quarterly royalty reports from OEMs related to their product sales.

 

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

 

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

 

Deferred Income Taxes and Related Valuation Allowance.  The amount, and ultimate realization, of our deferred income tax assets depends, in part, upon the tax laws in effect, our future earnings and other future events, the effects of which cannot be determined.  We have provided a valuation allowance of $52,908,000 against our entire net deferred tax asset as of October 31, 2003.  The valuation allowance was recorded because of our history of net operating losses and the uncertainties regarding our future operating profitability and taxable income.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Allowance for Doubtful Accounts.  We offer credit terms on the sale of our products to a majority of our customers and require no collateral from these customers.  We perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts based upon our historical collection experience and expected collectibility of all accounts receivable and have applied these policies consistently throughout the three months ended January 31, 2004.  Our allowance for doubtful accounts based on our historical experience and specific review as of January 31, 2004, was approximately $231,000.  Our past experience has resulted in minimal differences from the actual amounts provided for bad debts and our recorded estimates.  However, our actual bad debts in future periods may differ from our current estimates and the differences may be material, which may have an adverse impact on our future accounts receivable and cash position.

 

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Results of Operations

 

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

 

 

THREE MONTHS ENDED JANUARY 31, 2004 AND 2003

 

Revenue

 

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

 

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

 

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

 

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

 

The decrease in revenue from our International division for the first quarter of fiscal year 2004 compared to the first quarter of fiscal year 2003 was primarily related to the negative impact of the slowing European economy as well as from increased competition from other operating system products, particularly Linux, in Europe and Asia.  We anticipate for the remainder of the 2004 fiscal year that UNIX revenue generated in the Americas and the International divisions will be consistent with or slightly lower than revenue generated in the first quarter of fiscal year 2004 and that the percentage split between these two UNIX divisions will be generally consistent with that in the first quarter of fiscal year 2004.  Our UNIX product and services revenue may be lower than currently anticipated if we lose the support of any of our existing hardware and software vendors or our key industry partners withdraw their marketing and certification support or direct their support to our competitors.  This may occur as a result of our SCOsource initiatives and in particular as a result of any lawsuits we have brought and may bring against end users violating our intellectual property and contractual rights.

 

Products Revenue

 

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

 

Our products revenue consists of software licenses for UNIX products such as OpenServer and UnixWare, as well as sales of UNIX-related products.  Products revenue also includes revenue derived from OEMs.  We rely heavily on our two-tier distribution channel for approximately 50 percent of our products revenue in the Americas and approximately 90 percent of our revenue in our International division, and any disruption in our distribution channel could have an adverse impact on future revenue.

 

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

 

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

 

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

 

SCOsource Licensing Revenue

 

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

 

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

 

Services Revenue

 

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

 

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

 

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

 

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Cost of Products Revenue

 

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

 

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

 

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

 

Cost of SCOsource Licensing Revenue 

 

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

 

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

 

For the second quarter of fiscal year 2004, we expect our cost of SCOsource licensing revenue to be generally consistent with our cost of SCOsource license revenue generated in the first quarter of fiscal year 2004.  However, cost of SCOsource licensing revenue likely will fluctuate from quarter to quarter due in part to the unpredictability of the related SCOsource revenue and the level of legal and professional expenses incurred in connection with our efforts to protect our intellectual property rights.  Legal expenses could increase over time depending on developments in the litigation involving us.  Legal expenses may also include contingency payments made to the law firms engaged by us to protect our intellectual property rights.  Additionally, we are unable to predict the percentage of cost of SCOsource licensing revenue for future quarters due to the unpredictability of the related licensing revenue.

 

Cost of Services Revenue

 

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

 

Cost of services revenue includes the salaries and related personnel costs of employees delivering services revenue as well as third-party service agreements.  Cost of services revenue decreased by $370,000 for the first quarter of fiscal year 2004 compared to the first quarter of fiscal year 2003.  This decrease was attributable to reduced employee and related costs in our

 

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

 

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

 

Sales and Marketing

 

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

 

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

 

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

 

Research and Development

 

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

 

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

 

For the remaining quarters of fiscal year 2004, we anticipate the dollar amount of research and development expenses will remain consistent with, or increase slightly compared to, the first quarter of fiscal year 2004.

 

General and Administrative

 

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

 

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

 

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

 

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

 

Restructuring Charges (Reversals)

 

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

 

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

 

Amortization of Intangibles

 

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

 

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

 

Stock-based Compensation

 

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

 

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

 

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

 

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