424B3 1 a05-16101_2424b3.htm 424B3

 

PROSPECTUS SUPPLEMENT

 

Filed pursuant to Rule 424(b)(3) and 424(c)

(To Prospectus dated June 2, 2005)

 

Commission File No. 333-116732

 


 

THE SCO GROUP, INC.

 

 

2,105,263 Shares of Common Stock

 


 

This prospectus supplement supplements the prospectus dated June 2, 2005 relating to the offer and sale by the selling stockholder identified in the prospectus of up to 2,105,263 shares of common stock of The SCO Group, Inc.

 

This prospectus supplement includes a Quarterly Report on Form 10-Q filed on September 13, 2005.

 

This prospectus supplement should be read in conjunction with, and may not be delivered or utilized without, the prospectus dated June 2, 2005, and the prospectus supplements dated June 3, 2005, July 5, 2005 and July 15, 2005.  This prospectus supplement is qualified by reference to the prospectus and the prospectus supplements, except to the extent that the information in this prospectus supplement updates or supersedes the information contained in the prospectus dated June 2, 2005, or the prospectus supplements dated June 3, 2005, July 5, 2005 and July 15, 2005.

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete.  Any representation to the contrary is a criminal offense.

 


 

The SCO Group, Inc.
355 SOUTH 520 WEST, SUITE 100
LINDON, UTAH 84042
(801) 765-4999

 

 

The date of this prospectus supplement is September 13, 2005

 



 

UNITED STATES

 

SECURITIES AND EXCHANGE COMMISSION

 

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark one)

ý        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended July 31, 2005

 

OR

 

o        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from             to             

 

Commission file number 0-29911

 

THE SCO GROUP, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

87-0662823

(State or other jurisdiction of

 

(I.R.S. Employer Identification Number)

incorporation or organization)

 

 

 

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 such 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 o NO ý

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

YES o NO ý

 

As of September 8, 2005, there were 18,037,735 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.

Unaudited Financial Statements

 

 

Condensed Consolidated Balance Sheets as of July 31, 2005 and October 31, 2004

 

 

Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three and nine months ended July 31, 2005 and 2004

 

 

Condensed Consolidated Statements of Cash Flows for the nine months ended July 31, 2005 and 2004

 

 

Notes to Condensed Consolidated Financial Statements

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

Item 4.

Controls and Procedures

 

 

Forward-Looking Statements

 

 

Risk Factors

 

PART II.

OTHER INFORMATION

 

Item 1.

Legal Proceedings

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

Item 6.

Exhibits

 

 

Signatures

 

 



 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

 

 

July 31,

 

October 31,

 

 

 

2005

 

2004

 

 

 

(unaudited)

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

CURRENT ASSETS:

 

 

 

 

 

Cash and cash equivalents

 

$

6,526

 

$

12,693

 

Restricted cash

 

4,004

 

8,283

 

Available-for-sale securities

 

6,076

 

18,756

 

Accounts receivable, net of allowance for doubtful accounts of $109 and $136, respectively

 

4,947

 

6,638

 

Other current assets

 

2,376

 

1,870

 

Total current assets

 

23,929

 

48,240

 

 

 

 

 

 

 

PROPERTY AND EQUIPMENT:

 

 

 

 

 

Computer and office equipment

 

2,183

 

2,991

 

Leasehold improvements

 

389

 

406

 

Furniture and fixtures

 

96

 

103

 

 

 

2,668

 

3,500

 

Less accumulated depreciation and amortization

 

(2,090

)

(2,851

)

Net property and equipment

 

578

 

649

 

 

 

 

 

 

 

OTHER ASSETS:

 

 

 

 

 

Intangibles, net

 

3,383

 

5,413

 

Other assets

 

1,118

 

1,098

 

Total other assets

 

4,501

 

6,511

 

 

 

 

 

 

 

Total assets

 

$

29,008

 

$

55,400

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

CURRENT LIABILITIES:

 

 

 

 

 

Accounts payable

 

$

1,337

 

$

7,854

 

Payable to Novell, Inc.

 

425

 

3,283

 

Accrued compensation to law firms

 

 

7,956

 

Accrued payroll and benefits

 

2,270

 

3,369

 

Accrued liabilties

 

3,179

 

3,855

 

Deferred revenue

 

4,021

 

4,877

 

Other royalties payable

 

311

 

354

 

Income taxes payable

 

1,323

 

1,279

 

Total current liabilities

 

12,866

 

32,827

 

 

 

 

 

 

 

OTHER LONG-TERM LIABILITIES

 

340

 

343

 

 

 

 

 

 

 

COMMITMENTS AND CONTINGENCIES (Note 5)

 

 

 

 

 

 

 

 

 

 

 

COMMON STOCK SUBJECT TO RESCISSION (Note 6)

 

1,104

 

528

 

 

 

 

 

 

 

STOCKHOLDERS’ EQUITY:

 

 

 

 

 

Common stock, $0.001 par value; 45,000 shares authorized, 18,327 and 17,956 shares outstanding, respectively

 

18

 

18

 

Additional paid-in capital

 

246,652

 

246,273

 

Common stock held in treasury - 290 shares

 

(2,414

)

(2,414

)

Warrants outstanding

 

1,099

 

1,099

 

Deferred compensation

 

 

(22

)

Accumulated other comprehensive income

 

854

 

964

 

Accumulated deficit

 

(231,511

)

(224,216

)

Total stockholders’ equity

 

14,698

 

21,702

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

29,008

 

$

55,400

 

 

See accompanying notes to condensed consolidated financial statements.

 

4



 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(in thousands, except per share data)

 

 

 

Three Months Ended July 31,

 

Nine Months Ended July 31,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

(unaudited)

 

(unaudited)

 

REVENUE:

 

 

 

 

 

 

 

 

 

Products

 

$

7,953

 

$

8,929

 

$

23,095

 

$

27,056

 

SCOsource licensing

 

32

 

678

 

132

 

709

 

Services

 

1,368

 

1,598

 

4,249

 

4,969

 

Total revenue

 

9,353

 

11,205

 

27,476

 

32,734

 

 

 

 

 

 

 

 

 

 

 

COST OF REVENUE:

 

 

 

 

 

 

 

 

 

Products

 

695

 

741

 

1,902

 

2,364

 

SCOsource licensing

 

3,085

 

7,396

 

9,467

 

15,486

 

Services

 

700

 

878

 

2,195

 

3,273

 

Total cost of revenue

 

4,480

 

9,015

 

13,564

 

21,123

 

 

 

 

 

 

 

 

 

 

 

GROSS MARGIN

 

4,873

 

2,190

 

13,912

 

11,611

 

 

 

 

 

 

 

 

 

 

 

OPERATING EXPENSES:

 

 

 

 

 

 

 

 

 

Sales and marketing (exclusive of stock-based compensation of $0, $15, $14, and $61, respectively)

 

2,935

 

4,233

 

8,835

 

13,952

 

Research and development (exclusive of stock-based compensation of $0, $12, $8, and $36, respectively)

 

1,940

 

2,592

 

6,137

 

8,167

 

General and administrative (exclusive of stock-based compensation of $0, $243, $0, and $771, respectively)

 

1,647

 

1,889

 

5,446

 

5,793

 

Loss on impairment of long-lived assets

 

 

 

 

2,139

 

Severance and exit costs

 

 

 

 

682

 

Amortization of intangibles

 

593

 

593

 

1,779

 

1,973

 

Stock-based compensation

 

 

270

 

22

 

868

 

Total operating expenses

 

7,115

 

9,577

 

22,219

 

33,574

 

 

 

 

 

 

 

 

 

 

 

LOSS FROM OPERATIONS

 

(2,242

)

(7,387

)

(8,307

)

(21,963

)

 

 

 

 

 

 

 

 

 

 

EQUITY IN INCOME (LOSS) OF AFFILIATE

 

(19

)

41

 

51

 

115

 

 

 

 

 

 

 

 

 

 

 

OTHER INCOME (EXPENSE):

 

 

 

 

 

 

 

 

 

Interest income

 

122

 

186

 

257

 

698

 

Change in fair value of derivative

 

 

 

 

5,924

 

Other income (expense), net

 

(149

)

(87

)

1,025

 

(338

)

Total other income (expense), net

 

(27

)

99

 

1,282

 

6,284

 

 

 

 

 

 

 

 

 

 

 

LOSS BEFORE INCOME TAXES

 

(2,288

)

(7,247

)

(6,974

)

(15,564

)

 

 

 

 

 

 

 

 

 

 

PROVISION FOR INCOME TAXES

 

(84

)

(176

)

(321

)

(1,270

)

 

 

 

 

 

 

 

 

 

 

NET LOSS

 

(2,372

)

(7,423

)

(7,295

)

(16,834

)

 

 

 

 

 

 

 

 

 

 

CONTRIBUTIONS FROM (DIVIDENDS ON) REDEEMABLE CONVERTIBLE PREFERRED STOCK

 

 

14,924

 

 

7,123

 

 

 

 

 

 

 

 

 

 

 

NET INCOME ATTRIBUTABLE (LOSS APPLICABLE) TO COMMON STOCKHOLDERS

 

$

(2,372

)

$

7,501

 

$

(7,295

)

$

(9,711

)

 

 

 

 

 

 

 

 

 

 

BASIC NET INCOME (LOSS) PER COMMON SHARE

 

$

(0.13

)

$

0.49

 

$

(0.41

)

$

(0.67

)

DILUTED NET INCOME (LOSS) PER COMMON SHARE

 

$

(0.13

)

$

0.38

 

$

(0.41

)

$

(0.67

)

 

 

 

 

 

 

 

 

 

 

WEIGHTED AVERAGE BASIC COMMON SHARES OUTSTANDING

 

17,993

 

15,242

 

17,885

 

14,389

 

WEIGHTED AVERAGE DILUTED COMMON SHARES OUTSTANDING

 

17,993

 

19,912

 

17,885

 

14,389

 

 

 

 

 

 

 

 

 

 

 

OTHER COMPREHENSIVE LOSS

 

 

 

 

 

 

 

 

 

Net loss

 

$

(2,372

)

$

(7,423

)

$

(7,295

)

$

(16,834

)

Unrealized gain (loss) on available-for-sale securities, net of tax

 

5

 

(42

)

14

 

(160

)

Foreign currency translation adjustment, net of tax

 

(128

)

(132

)

(124

)

16

 

COMPREHENSIVE LOSS

 

$

(2,495

)

$

(7,597

)

$

(7,405

)

$

(16,978

)

 

See accompanying notes to condensed consolidated financial statements.

 

5



 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

 

 

Nine Months Ended July 31,

 

 

 

2005

 

2004

 

 

 

(unaudited)

 

 

 

 

 

 

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net loss

 

$

(7,295

)

$

(16,834

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Amortization of intangibles (including $251 and $253 classified as cost of SCOsource licensing revenue)

 

2,030

 

2,223

 

Depreciation and amortization

 

271

 

629

 

Stock-based compensation

 

22

 

868

 

Loss on impairment of long-lived assets

 

32

 

2,139

 

Equity in income of affiliates

 

(51

)

(115

)

Change in fair value of derivative

 

 

(5,924

)

Changes in operating assets and liabilities:

 

 

 

 

 

Restricted cash

 

1,421

 

 

Accounts receivable, net

 

1,691

 

3,328

 

Other current assets

 

(506

)

(16

)

Other assets

 

31

 

(204

)

Accounts payable

 

(6,517

)

(153

)

Accrued payroll and benefits

 

(1,099

)

(1,677

)

Compensation to law firms

 

(7,956

)

(2,600

)

Accrued liabilities

 

(676

)

6,995

 

Deferred revenue

 

(856

)

435

 

Other royalties payable

 

(43

)

(352

)

Taxes payable

 

44

 

562

 

Other long-term liabilities

 

(3

)

(7

)

Net cash used in operating activities

 

(19,460

)

(10,703

)

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Purchase of property and equipment

 

(233

)

(331

)

Purchase of available-for-sale securities

 

(8,224

)

(53,520

)

Proceeds from available-for-sale securities

 

20,904

 

20,010

 

Purchase of minority interest in Japanese subsidiary

 

 

(209

)

Net cash provided by (used in) investing activities

 

12,447

 

(34,050

)

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from sale of common stock through employee stock purchase program

 

720

 

810

 

Proceeds from exercise of common stock options

 

235

 

591

 

Offering costs incurred in connection with Series A-1 issuance

 

 

(211

)

Repurchase and retirement of Series A-1 convertible preferred stock

 

 

(13,000

)

Purchase of common stock

 

 

(2,414

)

Net cash provided by (used in) financing activities

 

955

 

(14,224

)

 

 

 

 

 

 

NET DECREASE IN CASH AND CASH EQUIVALENTS

 

(6,058

)

(58,977

)

EFFECT OF FOREIGN EXCHANGE RATES ON CASH

 

(109

)

131

 

CASH AND CASH EQUIVALENTS, beginning of period

 

12,693

 

64,428

 

CASH AND CASH EQUIVALENTS, end of period

 

$

6,526

 

$

5,582

 

 

 

 

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

 

 

 

 

 

 

 

 

 

 

 

Cash paid for income taxes

 

$

259

 

$

652

 

 

 

 

 

 

 

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:

 

 

 

 

 

 

 

 

 

 

 

Increase in common stock subject to rescission

 

$

576

 

$

557

 

 

 

 

 

 

 

Dividend in connection with exchange of Series A-1 Convertible Preferred Stock for Series A Convertible Preferred Stock

 

$

 

$

6,305

 

 

 

 

 

 

 

Accretion of dividends

 

$

 

$

2,047

 

 

 

 

 

 

 

Capital contribution in connection with repurchase and cancellation of Series A-1 Convertible Preferred Stock

 

$

 

$

(15,475

)

 

See accompanying notes to condensed consolidated financial statements.

 

6



 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

(1) ORGANIZATION AND DESCRIPTION OF BUSINESS

 

The business of The SCO Group, Inc. (the “Company”) focuses on marketing reliable, cost-effective UNIX software products and related services for the small-to-medium sized business market, including replicated site franchisees of Fortune 1000 companies. In January 2003, the Company established its SCOsource business and launched its first of several SCOsource initiatives to review and enforce its intellectual property surrounding the UNIX operating system. The Company acquired certain intellectual property rights surrounding UNIX and UNIX System V source code from The Santa Cruz Operation (now Tarantella, Inc.) in May 2001.

 

During the nine months ended July 31, 2005, the Company used cash of $19,460,000 in its operating activities. The majority of this cash was used to pay accounts payable, accrued compensation to law firms and liabilities related to the Company’s intellectual property litigation. As of July 31, 2005, the Company had a total of $12,602,000 in cash and cash equivalents and available-for-sale securities and an additional $4,004,000 in restricted cash, of which $3,579,000 is designated to be used as payments for experts, consultants and other expenses in the SCO Litigation (as defined herein). As a result of the Engagement Agreement between the Company and the law firms representing it in its intellectual property rights, the Company anticipates using cash of approximately $3,250,000 in the defense of its intellectual property litigation during the three months ending October 31, 2005. The Company expects that its UNIX business will generate sufficient cash in the year ending October 31, 2005 to cover the costs of its UNIX business as well as its internal costs for its SCOsource initiatives and believes that it will have sufficient cash resources to fund its operations through at least October 31, 2005.

 

In the event that cash required to fund operations and strategic initiatives exceeds the Company’s current cash resources and cash generated from operating activities, the Company will be required to reduce costs or raise additional capital. The Company may not be able to reduce costs in a manner that does not impair its ability to maintain its UNIX business and pursue its SCOsource initiatives. The Company also may have difficulty raising capital. If additional equity financing is available, it may not be available to the Company on attractive terms and may be dilutive to the Company’s existing stockholders. In addition, if the Company’s stock price declines, it may not be able to access the public equity markets on acceptable terms, if at all. The Company’s ability to effect acquisitions for stock would also be impaired.

 

(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 only of normal recurring adjustments, necessary to present fairly the financial information set forth therein. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to SEC rules and regulations, although the Company believes that

 

7



 

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. Operating results for the three and nine months ended July 31, 2005 are not necessarily indicative of the results that may be expected for the year ending October 31, 2005.

 

Use of Estimates in the Preparation of Financial Statements

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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 include, among others, revenue recognition, allowances for doubtful accounts receivable, severance and exit costs, 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. The Company’s revenue is primarily from three sources: (i) product license revenue, primarily from product sales to resellers, end users and original equipment manufacturers (“OEMs”); (ii) technical support service revenue, primarily from providing technical support and consulting services to end users; and (iii) revenue from its SCOsource initiatives.

 

The Company recognizes product revenue upon shipment if a signed contract exists, the fee is fixed or determinable, collection of the resulting receivable is probable and product returns are reasonably estimable.

 

The majority of the Company’s revenue transactions relate to product-only sales. On occasion, the Company has revenue transactions that have multiple elements (such as software products, maintenance, technical support services, 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 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 the remaining portion of the license fee is recognized as revenue in the period when persuasive evidence of an arrangement is obtained assuming all other revenue recognition criteria are met.

 

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

 

The Company considers an arrangement with payment terms longer than the Company’s normal business practice, which do not extend beyond 12 months, not to be fixed and determinable and revenue is recognized when the fee becomes due. The Company typically provides stock rotation rights for sales made through its distribution channel and sales to distributors are recognized upon shipment by the distributor to end users. For direct sales not through the Company’s distribution channel, sales are typically non-refundable and non-

 

8



 

cancelable. The Company estimates its product returns based on historical experience and maintains an allowance for estimated returns, which is recorded as a reduction to accounts receivable.

 

The Company’s SCOsource revenue to date has been primarily generated from agreements to utilize the Company’s UNIX source code as well as from intellectual property compliance agreements. The Company recognizes revenue from SCOsource 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 become due.

 

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, “Accounting for Stock Issued to Employees, and Related Interpretations.” 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. The compensation expense, if any, is amortized to expense over the vesting period.

 

Statement 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 prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation.” The fair value for the Company’s stock options is estimated on the date of grant using the Black-Scholes option-pricing model.

 

With respect to stock options and restricted stock awards granted and shares purchased pursuant to the Company’s 2000 Employee Stock Purchase Plan (the “ESPP”) during the three and nine months ended July 31, 2005 and 2004, the assumptions used in the Black-Scholes option-pricing model are as follows:

 

 

 

Three Months Ended July 31,

 

Nine Months Ended July 31,

 

 

 

2005

 

2004

 

2005

 

2004

 

Risk-free interest rate

 

4.1

%

3.1

%

3.7

%

2.8

%

Expected dividend yield

 

0.0

%

0.0

%

0.0

%

0.0

%

Volatility

 

47.1

%

87.6

%

65.0

%

84.2

%

Expected exercise life (in years)

 

2.7

 

2.9

 

2.7

 

3.0

 

 

9



 

For purposes of the pro forma disclosure, the estimated fair value of 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 income (loss) to common stockholders and the net income (loss) to common stockholders per basic and diluted common share for the three and nine months ended July 31, 2005 and 2004 (in thousands, except per share amounts):

 

 

 

Three Months Ended July 31,

 

Nine Months Ended July 31,

 

 

 

2005

 

2004

 

2005

 

2004

 

Net income (loss) applicable to common stockholders:

 

 

 

 

 

 

 

 

 

As reported

 

$

(2,372

)

$

7,501

 

$

(7,295

)

$

(9,711

)

Add back: Stock-based compensation included in reported net loss

 

 

270

 

22

 

868

 

Deduct: Stock-based compensation under fair value method

 

(569

)

(416

)

(1,166

)

(1,699

)

Pro forma net income (loss) applicable to common stockholders

 

$

(2,941

)

$

7,355

 

$

(8,439

)

$

(10,542

)

Net income (loss) applicable to common stockholders per basic common share:

 

 

 

 

 

 

 

 

 

As reported

 

$

(0.13

)

$

0.49

 

$

(0.41

)

$

(0.67

)

Pro forma

 

$

(0.16

)

$

0.48

 

$

(0.47

)

$

(0.73

)

Net income (loss) applicable to common stockholders per diluted common share:

 

 

 

 

 

 

 

 

 

As reported

 

$

(0.13

)

$

0.38

 

$

(0.41

)

$

(0.67

)

Pro forma

 

$

(0.16

)

$

0.37

 

$

(0.47

)

$

(0.73

)

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95,” which requires the measurement of all employee share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in the consolidated statements of operations and comprehensive loss. The accounting provisions of SFAS No. 123R are effective for the Company’s first fiscal year beginning after July 1, 2005, which will require the Company to adopt SFAS No. 123R for the three months ending January 31, 2006.

 

The above disclosure for the three and nine months ended July 31, 2005 and 2004 shows the pro forma net loss and net loss per common share as if the Company had used a fair-value-based method similar to the methods required under SFAS No. 123R to measure compensation expense for employee stock incentive awards. The Company is in the process of determining whether the adoption of SFAS No. 123R will result in future amounts that are similar to the pro forma disclosure above under SFAS No. 123, and adoption of SFAS No. 123R could have a material impact on the Company’s results of operations.

 

Cash and Cash Equivalents

 

The Company considers all investments purchased with original maturities of three or fewer months to be cash equivalents. Cash equivalents were $2,515,000 and $2,633,000 as of July 31, 2005 and October 31, 2004, respectively. Cash was $4,011,000 and $10,060,000 as of July 31, 2005 and October 31, 2004, respectively.

 

10



 

Available-for-Sale Securities

 

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 accumulated other comprehensive income. Realized gains and losses, which are calculated based on the specific-identification method, are recorded in operations as incurred.

 

Available-for-sale securities totaled $6,076,000 as of July 31, 2005 and consisted of government agency securities and corporate notes. Any available-for-sale securities in an unrealized loss position as of July 31, 2005 were not impaired at acquisition and the decline in fair value is primarily attributable to interest rate fluctuations. A decline in the market value of any available-for-sale security below cost that is deemed other than temporary results in a charge to earnings and establishes a new basis for the security.

 

Earnings per Share

 

Basic net income (loss) per common share (“Basic EPS”) is computed by dividing net income (loss) by the weighted average number 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, warrants to acquire common stock and preferred stock convertible into common shares. If dilutive, the Company computes Diluted EPS using the treasury stock method.

 

The following table is a reconciliation of the numerator and denominator of Basic EPS to the numerator and denominator of Diluted EPS for the three and nine months ended July 31, 2005 and 2004 (in thousands, except per share amounts):

 

 

 

Three Months Ended July 31,

 

Nine Months Ended July 31,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income attributable (loss applicable) to common stockholders

 

$

(2,372

)

$

7,501

 

$

(7,295

)

$

(9,711

)

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common basic shares outstanding

 

17,993

 

15,242

 

17,885

 

14,389

 

Convertible preferred stock

 

 

2,657

 

 

 

Stock options

 

 

1,740

 

 

 

Restricted stock

 

 

125

 

 

 

Warrants

 

 

148

 

 

 

Weighted average diluted common shares outstanding

 

17,993

 

19,912

 

17,885

 

14,389

 

Basic EPS

 

$

(0.13

)

$

0.49

 

$

(0.41

)

$

(0.67

)

Diluted EPS

 

$

(0.13

)

$

0.38

 

$

(0.41

)

$

(0.67

)

 

 

 

 

 

 

 

 

 

 

Excluded anti-dilutive common share equivalents

 

3,982

 

998

 

3,982

 

397

 

 

11



 

The excluded anti-dilutive common share equivalents are not included in the computation of Diluted EPS as their inclusion would be anti-dilutive to the net loss per common share.

 

Income Taxes

 

In October 2004, the American Jobs Creation Act (the “AJCA”) was signed into law. The AJCA includes a deduction of 85 percent of certain foreign earnings that are repatriated in the AJCA. The Company may elect to apply this provision to qualifying earnings repatriations in its year ending October 31, 2005. The Company does not believe that it will have any foreign earnings repatriation under the AJCA during the year ending October 31, 2005.

 

The Internal Revenue Code contains provisions that likely could reduce or limit the availability and utilization of net operating loss carry-forwards if certain changes in ownership have taken place or will take place. Ownership changes have occurred and utilization of the Company’s net operating loss carry-forwards may be limited pursuant to Internal Revenue Code Section 382 as a result of these ownership changes.

 

Reclassifications

 

Certain reclassifications have been made to prior periods’ amounts to conform to the current period presentation. The reclassifications had no effect on net income (loss) for the prior periods.

 

(3) INTANGIBLE ASSETS

 

The following table shows the activity related to amortizable intangible assets for the nine months ended July 31, 2005 as well as the remaining unamortized balances as of July 31, 2005 (in thousands):

 

 

 

As of
October 31, 2004

 

Nine Months Ended
July 31, 2005

 

As of
July 31, 2005

 

 

 

 

 

Amortization

 

Impairment

 

 

 

 

 

Net Book Value

 

Expense

 

Loss

 

Net Book Value

 

Amortizable intangible assets:

 

 

 

 

 

 

 

 

 

Distribution/reseller channel

 

$

4,636

 

$

(1,739

)

$

 

$

2,897

 

Acquired technology

 

673

 

(252

)

 

421

 

Trade name

 

104

 

(39

)

 

65

 

Total intangible assets

 

$

5,413

 

$

(2,030

)

$

 

$

3,383

 

 

Of the $2,030,000 in amortization expense, $1,779,000 was classified as amortization of intangible assets in operating expenses and the remaining $251,000 was classified as cost of SCOsource licensing revenue.

 

(4) INVESTMENTS

 

Sale of Troll Tech Shares

 

In December 1999, the Company and The Canopy Group, Inc. (“Canopy”), a former holder of the Company’s common stock, entered into an agreement with Troll Tech AS (“Troll Tech”) and its stockholders. Pursuant to the agreement, the Company acquired shares of Troll Tech in exchange for shares of the Company, and Canopy acquired shares of Troll Tech in exchange for $1,000,000. The Company recorded its investment in Troll Tech’s common stock at $400,000, based on the cash price per share paid by Canopy. The Company determined that the cash price per share paid by Canopy was the most reliable evidence of the value of Troll Tech’s

 

12



 

common stock. During the year ended October 31, 2001, management determined that the carrying value of the investment in Troll Tech of $400,000 would most likely not be recoverable, and the investment was written down to $0.

 

During the three months ended April 30, 2005, the Company received notice from Troll Tech that a third-party investor was interested in acquiring the Company’s shares of Troll Tech. On March 14, 2005, the Company received proceeds of $779,100 for the Troll Tech shares. The Company accounted for the sale and proceeds of the Troll Tech shares in the three months ended April 30, 2005 when it received the proceeds from the shares. All amounts related to the book value of the shares had been written off during the year ended October 31, 2001, and the Company recorded the proceeds received as a component of other income in its statement of operations and comprehensive loss for the nine months ended July 31, 2005.

 

(5) COMMITMENTS AND CONTINGENCIES

 

Litigation

 

The following includes updated information relating to certain of the Company’s material legal proceedings as previously reported in the Company’s annual report on Form 10-K for the year ended October 31, 2004, and previously updated in the Company’s quarterly reports on Form 10-Q for the three-month periods ended January 31, 2005 and April 30, 2005.

 

IBM Corporation

 

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

 

Following a hearing on October 19, 2004, on January 19, 2005, the United States Magistrate Judge overseeing discovery in the case issued an order granting in part and denying in part discovery applications that the Company had made. The Court ordered IBM to produce much of the information, including source code, revision information, and programmer- contribution information, that the Company had previously requested. The Court also struck the Amended Scheduling Order and directed the parties to submit a proposed amended scheduling order to the Court, which the parties did. The District Court heard argument on the proposed schedules on April 21, 2005. On July 1, 2005, the Court issued a revised scheduling order establishing, among other things, discovery and motion deadlines over the next 18 months with a five-week jury trial to commence on February 26, 2007.

 

In response to the Magistrate Court’s Order, IBM filed on February 11, 2005, a Motion for Reconsideration of the portion of the January 19 Order that required IBM to produce programmer-contribution information for 3,000 people. IBM also filed, on March 9, 2005, a Motion for a 45-day Extension of Time to Comply with the Court’s January 19 Order as it applies to materials that were not the subject of IBM’s above-referenced Motion for Reconsideration. On March 16, 2005, the Court granted the extension and entered an order requiring IBM to produce those materials by May 3, 2005. With respect to the materials covered by IBM’s Motion for Reconsideration, the Court granted IBM’s request to stay its discovery obligations pending the Court’s resolution of its motion.

 

13



 

On April 19, 2005, the Magistrate Court ruled on IBM’s reconsideration motion. The Court declined to strike its prior requirement that IBM produce documents from the files of the 3,000 individuals who made the most contributions and changes to the development of AIX and Dynix. The Court reiterated its requirement that IBM produce programmer’s notes, design documents, white papers, comments and notes, contact information, specific changes made to code, and all relevant non-privileged documents from the files of the 100 individuals who made the most contributions and changes to the development of AIX and Dynix; ordered IBM to provide a privilege log for any documents withheld from the files of those 100 individuals; and required IBM to comply within 90 days. The Court deferred the remainder of IBM’s required production pending the Company’s review of the above-described discovery. The Court also reiterated that IBM is required to produce all non-public Linux contribution information and directed IBM to produce all such information within 75 days.

 

On February 9, 2005, the United States District Judge ruled on several pending dispositive motions. The Court denied the three motions for partial summary judgment that IBM had filed on the Company’s contract claims, on IBM’s eighth counterclaim for copyright infringement, and on IBM’s tenth counterclaim for a declaration of non-infringement of the Company’s copyrights. The Court denied each of those motions without prejudice to IBM’s renewing or refiling the motions after discovery is complete. The Court also denied the Company’s motion to stay or dismiss IBM’s tenth counterclaim. The Court ordered that no further dispositive motions could be filed until the close of discovery, except by stipulation of the parties, and vacated its prior order, dated September 30, 2004, to the extent that order had granted permission to file dispositive motions before the close of discovery.

 

On January 12, 2005, the Company filed its Motion to Compel IBM to produce IBM CEO Samuel J. Palmisano for Deposition. The Court heard argument on that motion on April 21, 2005. On July 1, 2005, the Court issued an order granting the Company’s motion and ordered IBM to produce Mr. Palmisano for a four-hour deposition in New York. The Court found that Mr. Palmisano could have unique personal knowledge related to the claims in the case.

 

The parties have also now fully briefed the Company’s December 23, 2004 Renewed Motion to Compel Discovery, which seeks to compel IBM’s compliance with prior Court orders relating to IBM’s obligation (1) to produce all documents pertaining to Linux from the files of high-level IBM executives and board members; and (2) to produce witnesses to testify on several topics in two deposition notices that SCO has served on IBM. The Court has not set a hearing date for this motion.

 

On September 6, 2005, the Company filed a renewed motion to compel IBM to produce information relating to IBM’s work on the source code that IBM contributed to Linux where such information is in IBM’s hands and not publicly available.

 

In addition to the materials that have been publicly filed with the Court, certain information has been filed under seal in accordance with the protective order entered in the case. On November 30, 2004, a third party moved to intervene in the case for the purpose of challenging the sealing of certain documents filed with the Court, and additional groups subsequently joined in that motion. Following argument on April 26, 2005, by Order dated April 28, 2005, the Court denied the intervention motion. In its Order, the Court set forth various procedures to minimize the risk that documents would be improperly filed under seal. The parties have since directed the Clerk of the Court to unseal numerous previously sealed filings.

 

The Company also filed a motion for leave to file a third amended complaint in order to assert an additional copyright claim against IBM in the case. The Court heard argument on that fully briefed motion on April 21, 2005, and took the matter under advisement. In its July 1 order, the Court denied the Company’s motion. The Court first allowed IBM to narrow the scope of its

 

14



 

Ninth Counterclaim, and having done so concluded that SCO’s proposed new claim would expand the litigation and delay its resolution. The Court also opined that it appears that the Company or its predecessor-in-interest either knew or should have known about the conduct at issue in the new claim before the Company filed its original Complaint. The Company therefore will not pursue additional copyright remedies in this case regarding IBM’s alleged misuse of the Company’s code in its AIX product as set forth in the proposed amended complaint. The Company has explained in briefing and argument before the Court, however, that the predicate facts of the proposed copyright claim are already in the case as part of other claims.

 

Discovery is continuing in the case and the Company is reviewing that discovery.

 

Red Hat, Inc.

 

On August 4, 2003, Red Hat, Inc. (“Red Hat”) filed a complaint against the Company. The action is pending in the United States District Court for the District of Delaware under the case caption Red Hat, Inc. v. The SCO Group, Inc., Civil No. 03-772. 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 April 6, 2004, the court denied the Company’s motion to dismiss this case; however, the court stayed the case and requested status reports every 90 days regarding the case against IBM. Red Hat filed a motion for reconsideration, which the Court denied on March 31, 2005. The Company intends to vigorously defend this action. In the event the stay is lifted and Red Hat is allowed to pursue its claims, the Company will likely assert counterclaims against Red Hat.

 

Novell, Inc.

 

On January 20, 2004, the Company filed suit in Utah state court against Novell, Inc. (“Novell”) for slander of title seeking relief for its alleged bad faith effort to interfere with the Company’s ownership of copyrights related to its UNIX source code and derivative works and its UnixWare product. The case, after removal to federal court, is pending in the United States District Court for the District of Utah under the caption The SCO Group, Inc. v. Novell, Inc., Civil No. 2:04CV00139. In the lawsuit, the Company requested preliminary and permanent injunctive relief as well as damages. Through these claims, the Company seeks to 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 filed a second motion to dismiss claiming, among other things, that Novell’s false statements were not uttered with malice and are privileged under the law. The Court heard the argument on the motion on May 25, 2005. On June 27, 2005, the Court issued an order denying Novell’s motion. On July 29, 2005, Novell filed its Answer and Counterclaims against the Company, asserting counterclaims for the Company’s alleged breaches of the Asset Purchase Agreement between Novell and the Company’s predecessor-in-interest, The Santa Cruz Operation, Inc. (now Tarantella, Inc.), for slander of title, restitution/unjust enrichment, and accounting, and for declaratory relief regarding Novell’s alleged rights under the Asset Purchase Agreement. By stipulation of the parties and approval of the Court, the Company’s response to Novell’s Answer and Counterclaims was due and filed on September 12, 2005.

 

15



 

DaimlerChrysler Corporation

 

On or about March 3, 2004, the Company brought suit against DaimlerChrysler Corporation (“DaimlerChrysler”) for its alleged violations of its UNIX license agreement with the Company. The lawsuit alleges that DaimlerChrysler breached its UNIX software agreement by failing to provide an adequate or timely certification of its compliance with that agreement as the Company requested. The lawsuit, filed in Oakland County Circuit Court in the State of Michigan, requests the court to declare 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 an 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.

 

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

 

AutoZone, Inc.

 

On or about 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. The lawsuit alleges copyright infringement by AutoZone by, among other things, running versions of the Linux operating system that contain proprietary material from UNIX System V. The lawsuit, filed in United States 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. In response to AutoZone’s motion to transfer the case to Tennessee or stay the case, the federal court in Nevada granted AutoZone’s motion to stay the case, with 90-day status reports to the court, and denied without prejudice AutoZone’s motion to transfer the case to Tennessee. The federal court allowed the parties to take limited expedited discovery relating to the issue of preliminary injunctive relief which discovery was concluded in May 2005.

 

The Company has concluded the initial discovery allowed by the court and filed its report with the court on May 27, 2005. Contrary to AutoZone’s own statements to the court, the Company found through discovery, including depositions and other admissions of AutoZone, many instances of copying of programs containing SCO OpenServer code. AutoZone has represented that it has now removed all of the SCO code and proprietary information it copied or used in its migration to Red Hat Linux. Because AutoZone represents it has removed or otherwise is not using SCO code and proprietary information, the Company currently does not intend to move for a preliminary injunction. AutoZone does not admit that it violated the Company’s rights or caused the Company damage in that migration process, which are still points of dispute between the parties. Given the stay issued by the court in the case, the Company reserves the right to pursue infringement and damages in the future based on these issues and other issues stayed by the court.

 

16



 

IPO Class Action Matter

 

The Company is an issuer defendant in a series of class action lawsuits involving over 300 issuers that have been consolidated under In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). The consolidated complaint alleges, among other things, certain improprieties regarding the underwriters’ conduct during the Company’s initial public offering and the failure to disclose such conduct in the registration statement in violation of the Securities Act of 1933, as amended.

 

The plaintiffs, the issuers and the insurance companies have negotiated an agreement to settle the dispute between the plaintiffs and the issuers. All parties, including the plaintiffs, issuers and insurance companies, have executed this settlement agreement and the settlement agreement has been submitted to the court for approval. If the settlement agreement is approved by the court, 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 directors.

 

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 and will not exceed the $200,000 self-insured retention already paid or accrued by the Company.

 

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 and/or give a security deposit 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. The distributor additionally requested that the Indian courts grant interim relief in the form of attachment of local assets. 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. Discovery has commenced and hearings on the requests for interim relief 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 will be substantial. The ultimate outcome or potential effect on the Company’s results of operations or financial position 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. 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.

 

Grants of Unregistered Stock Options; Potential Interest and Penalties Related to Rescission Rights

 

The Company believes certain shares and options granted under its 1998 Stock Option Plan, 1999 Omnibus Stock Option Plan, the ESPP, 2002 Omnibus Stock Incentive Plan, and 2004 Omnibus Stock Incentive Plan (collectively, the “Equity Compensation Plans”) were issued without complying with registration or qualification requirements under federal securities laws and the securities laws of California, Utah and possibly other states. As a result, certain plan participants have a right to rescind their purchases of shares under the Equity Compensation Plans or recover damages if they no longer own the shares or hold unexercised options, subject to applicable statutes of limitations. Additionally, regulatory authorities may require the Company

 

17



 

to pay fines or impose other sanctions. On July 28, 2005, the Company filed a registration statement on Form S-1 with the SEC to register the repurchase by the Company of approximately 313,000 shares issued under the ESPP from current or former participants in the ESPP. As of the date of the filing of this quarterly report on Form 10-Q, the SEC has not declared the Form S-1 registration statement effective.

 

The Company believes certain of its stock option grants made since February 2003 may have also violated applicable securities laws in California, Georgia and possibly other states even though holders have not exercised such options. Because the options in question have not been exercised, no amounts are recorded in permanent equity. The Company has not included in its proposed registration statement on Form S-1 the repurchase of shares to be issued upon the exercise of these stock options. Since any loss may be considered reasonably possible but not estimable, the Company has not recorded a liability for this contingency.

 

The Company may also be required to pay interest and penalties up to statutory limits in connection with plan participants making rescission claims. The Company believes that it is reasonably possible that it may be required to pay interest and penalties, but it is not able to estimate an amount.

 

(6) COMMON STOCK SUBJECT TO RESCISSION

 

As described in Note 5, certain participants in the Equity Compensation Plans have a right to rescind their purchases of shares under the Equity Compensation Plans or recover damages if they no longer own the shares or hold unexercised options, subject to applicable statutes of limitations.

 

Accounting Series Release (“ASR”) No. 268 and Emerging Issues Task Force (“EITF”) Topic D-98 require that stock subject to rescission or redemption requirements outside the control of the Company be classified outside of permanent equity. The exercise of the rescission right is at the holders’ discretion, but exercise of that right may depend in part on the fair value of the Company’s common stock, which is outside of the Company’s and the holders’ control. Consequently, common stock subject to rescission is classified as temporary equity. If the Company’s rescission offer becomes effective and is accepted by plan participants holding shares acquired under the ESPP or otherwise entitled to recover damages from the Company in respect of such shares they have sold, or other plan participants otherwise make rescission claims against the Company, the Company could be required to make aggregate payments to all such plan participants of up to $1,104,000, excluding interest and other possible fees, based upon shares outstanding under the Equity Compensation Plans as of July 31, 2005.

 

Upon the completion of the Company’s rescission offer or if plan participants otherwise exercise rescission rights, any amounts the Company may pay to plan participants, excluding interest and other possible charges, will be deducted from common stock subject to rescission, and, in the event a plan participant declines a rescission offer or otherwise is determined to no longer have a rescission right, any remaining amounts recorded to common stock subject to rescission will be recorded as permanent equity.

 

(7) STOCKHOLDERS’ EQUITY

 

Stock Options

 

During the three and nine months ended July 31, 2005, the Company granted options to purchase 321,000 and 952,000 shares of common stock with an average exercise price of $3.93 and $4.44, respectively, per share. None of these stock options were granted with an exercise price below the quoted market price on the date of grant. During the three and nine months ended July 31, 2005, options to purchase approximately 17,000 and 159,000 shares of common stock were

 

18



 

exercised with an average exercise price of $1.79 and $1.48, respectively, per share. As of July 31, 2005, there were approximately 3,722,000 stock options outstanding with a weighted average exercise price of $4.25 per share.

 

Change in Control Agreements

 

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

 

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

 

If the Officer is still employed by the Company when a Change in Control occurs, any stock, stock option or restricted stock granted to the Officer by the Company that would have become vested upon continued employment by the Officer shall immediately vest in full and become exercisable notwithstanding any provision to the contrary of such grant and shall remain exercisable until it expires or terminates in accordance with its terms. Each Officer shall be solely responsible for any taxes that arise or become due pursuant to the acceleration of vesting that occurs pursuant to the Change in Control Agreement.

 

The adoption of the Change in Control Agreements allows for accelerated vesting on all outstanding shares of common stock and represents a modification to the underlying stock option award. In accordance with FASB Interpretation No. 44 “Accounting for Certain Transactions Involving Stock Compensation,” the Company has calculated the total intrinsic value of the awards of $2,012,000, which represents the value of the awards that were subject to the acceleration. During the three and nine months ended July 31, 2005, this amount had not been recorded in the condensed consolidated financial statements as an event to trigger the acceleration was not considered probable.

 

Stockholder Rights Plan

 

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

 

Under the terms of the Rights Plan, Series A Junior Participating Preferred Stock purchase rights were distributed as a dividend at the rate of one right for each share of common stock of the Company held by stockholders of record as of the close of business on August 30, 2004, and will be distributed to holders of subsequently issued shares of common stock. The Rights Plan would be triggered if a person or group acquired beneficial ownership of 15 percent or more of the Company’s common stock other than pursuant to a board-approved tender or exchange offer or commences, or publicly announces an intention to commence, a tender or exchange offer upon consummation of which such person or group would beneficially own 15 percent or more of the Company’s common stock. The value of the purchase rights is immaterial as of July 31, 2005.

 

19



 

Transfer of Stock Ownership by The Canopy Group to Ralph J. Yarro III

 

Effective March 11, 2005, The Canopy Group (“Canopy”) transferred all of its shares of the Company’s common stock to Ralph J. Yarro III, the Chairman of the Company’s Board of Directors.

 

(8) CONCENTRATION OF RISK

 

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

 

During the three and nine months ended July 31, 2005 and 2004, no single customer accounted for more than 10 percent of total revenue.

 

(9) RELATED PARTY TRANSACTIONS

 

As of October 31, 2004, Canopy owned approximately 31 percent of the Company’s issued and outstanding common stock. As described in Note 7, on March 11, 2005, Canopy transferred all of its shares of common stock to Ralph J. Yarro III.

 

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

 

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

 

In late November 2004, the Company entered into discussions with Vintela with respect to the cancellation of the Marketing Agreement and repayment of the Note. It was later agreed that once Vintela had received funding from an outside third party, the Company would forego any interest charges on the promissory note in return for an immediate payment of the $500,000. On December 9, 2004, the Company received the $500,000 payment from Vintela and forgave the outstanding interest charges associated with the promissory note.

 

At the time the promissory note was executed, the Company had no recorded basis in the Assigned Software. Because the transfer of the Assigned Software was to a related party in exchange for a promissory note and there was substantial doubt concerning the ability of C7 to repay the debt as they were not profitable and being funded by Canopy, no gain was recognized by the Company until payment was received on December 9, 2004. The Company recorded the $500,000 received as a component of other income in its statement of operations and comprehensive loss for the nine months ended July 31, 2005.

 

(10) SEGMENT INFORMATION

 

The Company’s resources are allocated and operating results managed to the operating income (loss) level for each of the Company’s segments: UNIX and SCOsource. Both segments

 

20



 

are based on the Company’s UNIX intellectual property. The UNIX business sells and distributes UNIX products and services through an extensive distribution channel and to corporate end-users and the SCOsource busness enforces and protects the Company’s UNIX intellectual property.

 

Segment disclosures for the Company are as follows for the three and nine months ended July 31, 2005 (in thousands):

 

 

 

Three Months Ended July 31, 2005

 

 

 

UNIX

 

SCOsource

 

Total

 

 

 

 

 

 

 

 

 

Revenue

 

$

9,321

 

$

32

 

$

9,353

 

Cost of revenue

 

1,395

 

3,085

 

4,480

 

Gross margin (deficit)

 

7,926

 

(3,053

)

4,873

 

Sales and marketing

 

2,935

 

 

2,935

 

Research and development

 

1,843

 

97

 

1,940

 

General and administrative

 

1,556

 

91

 

1,647

 

Other

 

593

 

 

593

 

Total operating expenses

 

6,927

 

188

 

7,115

 

Income (loss) from operations

 

$

999

 

$

(3,241

)

$

(2,242

)

 

 

 

Three Months Ended July 31, 2004

 

 

 

UNIX

 

SCOsource

 

Total

 

 

 

 

 

 

 

 

 

Revenue

 

$

10,527

 

$

678

 

$

11,205

 

Cost of revenue

 

1,619

 

7,396

 

9,015

 

Gross margin (deficit)

 

8,908

 

(6,718

)

2,190

 

Sales and marketing

 

3,740

 

493

 

4,233

 

Research and development

 

2,361

 

231

 

2,592

 

General and administrative

 

1,761

 

128

 

1,889

 

Other

 

863

 

 

863

 

Total operating expenses

 

8,725

 

852

 

9,577

 

Income (loss) from operations

 

$

183

 

$

(7,570

)

$

(7,387

)

 

21



 

 

 

Nine Months Ended July 31, 2005

 

 

 

UNIX

 

SCOsource

 

Total

 

 

 

 

 

 

 

 

 

Revenue

 

$

27,344

 

$

132

 

$

27,476

 

Cost of revenue

 

4,097

 

9,467

 

13,564

 

Gross margin (deficit)

 

23,247

 

(9,335

)

13,912

 

Sales and marketing

 

8,681

 

154

 

8,835

 

Research and development

 

5,838

 

299

 

6,137

 

General and administrative

 

5,094

 

352

 

5,446

 

Other

 

1,801

 

 

1,801

 

Total operating expenses

 

21,414

 

805

 

22,219

 

Income (loss) from operations

 

$

1,833

 

$

(10,140

)

$

(8,307

)

 

 

 

Nine Months Ended July 31, 2004

 

 

 

UNIX

 

SCOsource

 

Total

 

 

 

 

 

 

 

 

 

Revenue

 

$

32,025

 

$

709

 

$

32,734

 

Cost of revenue

 

5,637

 

15,486

 

21,123

 

Gross margin (deficit)

 

26,388

 

(14,777

)

11,611

 

Sales and marketing

 

12,868

 

1,084

 

13,952

 

Research and development

 

7,838

 

329

 

8,167

 

General and administrative

 

5,643

 

150

 

5,793

 

Other

 

5,662

 

 

5,662

 

Total operating expenses

 

32,011

 

1,563

 

33,574

 

Loss from operations

 

$

(5,623

)

$

(16,340

)

$

(21,963

)

 

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

 

 

 

 

 

July 31,
2005

 

October 31,
2004

 

Intangible assets:

 

 

 

 

 

 

 

UNIX (reseller channel and trade name)

 

 

 

$

2,962

 

$

4,740

 

SCOsource (UNIX technology)

 

 

 

421

 

673

 

Total intangible assets

 

 

 

$

3,383

 

$

5,413

 

 

22



 

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, 2004 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 the three and nine months ended July 31, 2005. 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”), 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 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. As used herein, “we,” “us” and the “Company” refer to The SCO Group, Inc.

 

Recent Developments. As described elsewhere in this Form 10-Q, we issued certain shares and granted certain options under our 1998 Stock Option Plan, our 1999 Omnibus Stock Incentive Plan, the 2000 Employee Stock Purchase Plan (the “ESPP”), our 2002 Omnibus Stock Incentive Plan, and our 2004 Omnibus Stock Incentive Plan (collectively, the “Equity Compensation Plans”) without complying with registration or qualification requirements under federal securities laws or the securities laws of California, Utah and possibly other states. As a result, certain plan participants have a right to rescind their purchases of shares under the Equity Compensation Plans or recover damages if they no longer own the shares or hold unexercised options, subject to applicable statutes of limitations. We are currently in the process of preparing a rescission offer for participants in the ESPP entitled to rescission rights, subject to obtaining required regulatory approvals. On July 28, 2005, we filed a registration statement on Form S-1 with the SEC to register our repurchase of approximately 313,000 shares issued under the ESPP from current or former participants in the ESPP. As of the date of the filing of this quarterly report on Form 10-Q, the SEC has not declared the Form S-1 registration statement effective. If our potential rescission offer is made and accepted by all plan participants holding certain ESPP shares, or participants in the Equity Compensation Plans otherwise make rescission claims against us, we could be required to make aggregate payments to these plan participants of up to $1,104,000. This amount is based on shares issued pursuant to the ESPP and shares issued upon the exercise of stock options that have been retained by plan participants as of July 31, 2005 and excludes interest and other charges we may be required to pay since any loss is considered reasonably possible but not estimable. We may face additional rescission liability to plan participants holding unexercised

 

23



 

stock options in California, Georgia and possibly other states, and regulatory authorities also may require us to pay fines or impose other sanctions on us.

 

Business Focus

 

We generate revenue from sales of products and services from our UNIX business and from sales of SCOsource intellectual property (“IP”) agreements and vendor licenses from our SCOsource 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 software technology for distributed, embedded and network-based systems. Our largest source of UNIX business revenue is derived from existing customers through our worldwide, indirect, leveraged channel of partners which includes distributors and independent solution providers. We have a presence in a number of countries that provide support and services to customers and resellers. The other principal channel for selling and marketing our UNIX products is through existing customers 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 (“ASMs”) 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 original equipment manufacturers (“OEMs”). Our sales of UNIX products and services during the last several quarters have been primarily to pre-existing UNIX customers and not newly acquired customers. Our UNIX business revenue depends significantly on our ability to market and sell our products to existing customers and to generate upgrades from existing customers.

 

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

 

 

 

Three Months Ended July 31,

 

Nine Months Ended July 31,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

9,321

 

$

10,527

 

$

27,344

 

$

32,025

 

Cost of revenue

 

1,395

 

1,619

 

4,097

 

5,637

 

Gross margin

 

7,926

 

8,908

 

23,247

 

26,388

 

Sales and marketing

 

2,935

 

3,740

 

8,681

 

12,868

 

Research and development

 

1,843

 

2,361

 

5,838

 

7,838

 

General and administrative

 

1,556

 

1,761

 

5,094

 

5,643

 

Other

 

593

 

863

 

1,801

 

5,662

 

Total operating expenses

 

6,927

 

8,725

 

21,414

 

32,011

 

Income (loss) from operations

 

$

999

 

$

183

 

$

1,833

 

$

(5,623

)

 

Revenue from our UNIX business decreased by $1,206,000, or 11 percent, for the three months ended July 31, 2005 compared to the three months ended July 31, 2004 and decreased by $4,681,000, or 15 percent, for the nine months ended July 31, 2005 compared to the nine months ended July 31, 2004. The revenue from this business has been declining over the last several quarters primarily as a result of increased competition from alternative operating systems, particularly Linux. If revenue from our UNIX business declines and our UNIX business is unable to generate positive cash flow, our results of operations will be adversely impacted.

 

24



 

In an effort to attain profitability in our UNIX business, we have decreased our operating costs and streamlined our operations. Operating costs for our UNIX business decreased from $8,725,000 for the three months ended July 31, 2004 to $6,927,000 for the three months ended July 31, 2005 and decreased from $32,011,000 for the nine months ended July 31, 2004 to $21,414,000 for the nine months ended July 31, 2005. These cost reductions have primarily been attributable to reduced headcount, continued operational efficiencies generated in our UNIX business, the elimination of certain write-offs and severance and exit costs, as well as from the consolidation of certain facilities.

 

In our UNIX business, we have reduced the number of full-time equivalent employees from 224 as of July 31, 2004, to 163 as of July 31, 2005. We have taken these headcount reductions and reduced other discretionary spending while still maintaining a worldwide presence. Based on our cost-cutting actions, we anticipate that our UNIX business will continue to generate income from operations and positive cash flow for the three months ending October 31, 2005.

 

The decline in our UNIX business revenue may be accelerated if industry partners withdraw their support as a result of our SCOsource initiatives. The decline in our UNIX business and our SCOsource initiatives 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 revenue from our UNIX business.

 

An important initiative for our UNIX business for the year ending October 31, 2005 was the release of the next major upgrade to our OpenServer product, OpenServer 6, which was completed in June 2005. OpenServer 6 provides increased system reliability, backward compatibility with existing applications and software, increased application and hardware support, integration with widely used internet applications and increased system performance. We anticipate that these enhancements will not have a direct impact on our short-term OpenServer revenue because of the long adoption cycle for new operating system purchases and our long operating system product sales cycle, but we believe that they will help prolong our OpenServer revenue stream for future quarters.

 

SCOsource Business. During the year ended October 31, 2003, 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 but pay only minimal fees, if any, for service and maintenance. The Linux operating system competes directly with our UNIX products and has taken significant market share from these products.

 

In an effort to protect our UNIX intellectual property, we initiated our SCOsource business. The initiatives of this business include seeking to enter into license agreements with UNIX vendors and offering SCOsource IP agreements to Linux and other end users allowing them to continue to use our UNIX source code and derivative works found in Linux. We believe that our SCOsource revenue opportunities have been adversely impacted by our outstanding dispute with Novell over our UNIX copyright ownership, which may have caused many potential customers to delay or forego licensing until an outcome in this legal matter has been reached.

 

25



 

The following table shows the operating results of the SCOsource business for the three and nine months ended July 31, 2005 and 2004 (in thousands):

 

 

 

Three Months Ended July 31,

 

Nine Months Ended July 31,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

32

 

$

678

 

$

132

 

$

709

 

Cost of revenue

 

3,085

 

7,396

 

9,467

 

15,486

 

Gross deficit

 

(3,053

)

(6,718

)

(9,335

)

(14,777

)

Sales and marketing

 

 

493

 

154

 

1,084

 

Research and development

 

97

 

231

 

299

 

329

 

General and administrative

 

91

 

128

 

352

 

150

 

Total operating expenses

 

188

 

852

 

805

 

1,563

 

Loss from operations

 

$

(3,241

)

$

(7,570

)

$

(10,140

)

$

(16,340

)

 

Revenue from our SCOsource business decreased from $678,000 for the three months ended July 31, 2004 to $32,000 for the three months ended July 31, 2005 and decreased from $709,000 for the nine months ended July 31, 2004 to $132,000 for the nine months ended July 31, 2005. Revenue in the above-mentioned periods was primarily attributable to sales of our SCOsource IP agreements. Because of the uncertainties related to our SCOsource business, we are unable to estimate the amount and timing of future SCOsource 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. We are unlikely to generate significant revenue from our SCOsource business unless and until we prevail in our litigation with IBM, Red Hat, Novell, Daimler Chrysler and AutoZone (the “SCO Litigation”). 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.

 

Cost of revenue, which primarily includes legal and professional fees incurred in connection with the SCO Litigation, decreased from $7,396,000 in the three months ended July 31, 2004 to $3,085,000 in the three months ended July 31, 2005 and decreased from $15,486,000 in the nine months ended July 31, 2004 to $9,467,000 in the nine months ended July 31, 2005. The decrease in cost of revenue is primarily attributable to our modified fee agreement with the law firms (the “Law Firms”) representing us in the SCO Litigation that has significantly reduced our ongoing and future operating expenses. Operating expenses for sales and marketing, research and development and general and administrative decreased in the three and nine months ended July 31, 2005 from the three and nine months ended July 31, 2004, which was primarily attributable to decreased personnel and related costs.

 

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

 

26



 

Critical Accounting Policies

 

Our critical accounting policies and estimates include the following:

 

                              Revenue recognition;

 

                              Deferred income taxes and related valuation allowances;

 

                              Severance and exit costs;

 

                              Impairment of long-lived assets; and

 

                              Allowance for doubtful accounts.

 

Revenue Recognition. We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, as modified by SOP 98-9. Revenue recognition in accordance with these pronouncements is complex due to the nature and variability of our sales transactions. We recognize products revenue upon shipment if a signed contract exists, the fee is fixed or determinable, collection of the resulting receivable is probable and product returns are reasonably estimable.

 

The majority of our revenue transactions relate to product–only sales. On occasion we have revenue transactions that include multiple elements (such as products, maintenance, technical support services and other services). For software agreements that have multiple elements, we allocate revenue to each component of the contract based on vendor specific objective evidence (“VSOE”). VSOE is established when such elements are sold separately. We recognize revenue 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 the remaining portion of the license fee is recognized as revenue in the period when persuasive evidence of an arrangement is obtained assuming all other revenue recognition criteria are met. We recognize revenue allocated to undelivered products when the criteria for revenue recognition set forth above have been met.

 

Estimates used in revenue recognition include the determination of credit-worthiness of our customers, verification of sales-out reporting to end users through our two-tier distribution channel and the estimation of potential returns. In addition to these estimates, we also provide reserves against revenue based on historical trends and experience. To the extent our estimates are incorrect, or we are not able to maintain VSOE, our recognized revenue could 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 revenue recognition in future periods may be impacted because a larger component of revenue may be deferred.

 

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

 

Severance and Exit Costs. Since the year ended October 31, 2001, we have undertaken significant restructuring activities to reduce our ongoing cost of operations. All restructurings that occurred prior to the year ended October 31, 2003 were accounted for in accordance with Emerging Issues Task Force (“EITF”) No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” For restructuring activities initiated beginning with

 

27



 

the year ended October 31, 2003, we have accounted for the one-time termination benefits, contract termination costs and other associated costs in accordance with SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities.” Other severance benefits have been accounted for in accordance with SFAS No. 112 “Employers’ Accounting for Postemployment Benefits.” and SFAS No. 88 “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Plans and for Termination Benefits.”

 

Each restructuring has required us to make estimates and assumptions related to losses on vacated facilities, provisions for termination benefits, outplacement costs and other costs. Pursuant to the relevant accounting literature, we may record an accrual for amounts associated with a restructuring that are not paid in the current period. We regularly evaluate the adequacy of the accruals based on changes in estimates. We may incur future charges for new restructuring activities. As of July 31, 2005, we did not have any amounts accrued for severance and exit costs.

 

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 value of the long-lived asset.

 

If the operating trends for our UNIX or SCOsource businesses decline, we may be required to record an impairment charge in a future period related to the carrying value of our long-lived assets.

 

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 last three fiscal years. Our allowance for doubtful accounts, which is determined based on our historical experience and a specific review of customer balances, was $109,000 as of July 31, 2005. 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.

 

28



 

Results of Operations

 

The following table presents our results of operations for the three and nine months ended July 31, 2005 and 2004 (in thousands):

 

 

 

Three Months Ended July 31,

 

Nine Months Ended July 31,

 

 

 

2005

 

2004

 

2005

 

2004

 

Statement of Operations Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

 

Products

 

$

7,953

 

$

8,929

 

$

23,095

 

$

27,056

 

SCOsource licensing

 

32

 

678

 

132

 

709

 

Services

 

1,368

 

1,598

 

4,249

 

4,969

 

Total revenue

 

9,353

 

11,205

 

27,476

 

32,734

 

Cost of revenue:

 

 

 

 

 

 

 

 

 

Products

 

695

 

741

 

1,902

 

2,364

 

SCOsource licensing

 

3,085

 

7,396

 

9,467

 

15,486

 

Services

 

700

 

878

 

2,195

 

3,273

 

Total cost of revenue

 

4,480

 

9,015

 

13,564

 

21,123

 

Gross margin

 

4,873

 

2,190

 

13,912

 

11,611

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

2,935

 

4,233

 

8,835

 

13,952

 

Research and development

 

1,940

 

2,592

 

6,137

 

8,167

 

General and administrative

 

1,647

 

1,889

 

5,446

 

5,793

 

Loss on disposition of long-lived assets

 

 

 

 

2,139

 

Severance and exit costs

 

 

 

 

682

 

Amortization of intangibles

 

593

 

593

 

1,779

 

1,973

 

Stock-based compensation

 

 

270

 

22

 

868

 

Total operating expenses

 

7,115

 

9,577

 

22,219

 

33,574

 

Loss from operations

 

(2,242

)

(7,387

)

(8,307

)

(21,963

)

Equity in income (losses) of affiliate

 

(19

)

41

 

51

 

115

 

Other income (expense), net

 

(27

)

99

 

1,282

 

6,284

 

Provision for income taxes

 

(84

)

(176

)

(321

)

(1,270

)

Net loss

 

(2,372

)

(7,423

)

(7,295

)

(16,834

)

Contributions from (dividends on) redeemable convertible preferred stock

 

 

14,924

 

 

7,123

 

Net income attributable (loss applicable) to common stockholders

 

$

(2,372

)

$

7,501

 

$

(7,295

)

$

(9,711

)

 

THREE AND NINE MONTHS ENDED JULY 31, 2005 AND 2004

 

Revenue

 

 

 

Three Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

Revenue

 

$

9,353,000

 

(17

)%

$

11,205,000

 

 

 

 

Nine Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

Revenue

 

$

27,476,000

 

(16

)%

$

32,734,000

 

 

Revenue for the three months ended July 31, 2005 decreased by $1,852,000, or 17 percent, from the three months ended July 31, 2004, and revenue for the nine months ended July 31, 2005 decreased by $5,258,000, or 16 percent, from the nine months ended July 31, 2004. These

 

29



 

decreases were primarily attributable to a continued decline in the revenue generated from our UNIX business and a decline in revenue from our SCOsource business.

 

Revenue generated from our UNIX business and SCOsource business is as follows:

 

 

 

Three Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

UNIX revenue

 

$

9,321,000

 

(11

)%

$

10,527,000

 

Percent of total revenue

 

100

%

 

 

94

%

SCOsource revenue

 

32,000

 

(95

)%

678,000

 

Percent of total revenue

 

0

%

 

 

6

%

 

 

 

Nine Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

UNIX revenue

 

$

27,344,000

 

(15

)%

$

32,025,000

 

Percent of total revenue

 

100

%

 

 

98

%

SCOsource revenue

 

132,000

 

(81

)%

709,000

 

Percent of total revenue

 

0

%

 

 

2

%

 

The decrease in revenue in the UNIX business of $1,206,000 for the three months ended July 31, 2005 compared to the three months ended July 31, 2004 and the decrease in UNIX revenue of $4,681,000 for the nine months ended July 31, 2005 compared to the nine months ended July 31, 2004 was primarily attributable to continued competition from other operating systems, particularly Linux. We anticipate that for the three months ending October 31, 2005 and for future periods our UNIX business and the related revenue from the UNIX business will face significant competition from Linux and other operating systems. The decrease in SCOsource revenue for the three and nine months ended July 31, 2005 compared to the three and nine months ended July 31, 2004 was primarily attributable to decreased sales of SCO IP agreements.

 

Sales of our UNIX products and services during the three and nine months ended July 31, 2005 were primarily to pre-existing customers. Our UNIX business revenue depends significantly on our ability to market our products to existing customers and to generate upgrades from existing customers. Our UNIX revenue may be lower than currently anticipated if we are not successful with our existing customers or 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 the decline of our UNIX business and our SCOsource initiatives.

 

Products Revenue

 

 

 

Three Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

Products revenue

 

$

7,953,000

 

(11

)%

$

8,929,000

 

Percent of total revenue

 

85

%

 

 

80

%

 

 

 

Nine Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

Products revenue

 

$

23,095,000

 

(15

)%

$

27,056,000

 

Percent of total revenue

 

84

%

 

 

83

%

 

30



 

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, distribution partners and large accounts. We rely heavily on our two-tier distribution channel and any disruption in our distribution channel could have an adverse impact on future revenue.

 

The decrease in products revenue of $976,000 from the three months ended July 31, 2005 compared to the three months ended July 31, 2004 and the decrease in products revenue of $3,961,000 from the nine months ended July 31, 2005 compared to the nine months ended July 31, 2004 was primarily attributable to decreased sales of OpenServer and UnixWare products primarily resulting from increased competition in the operating system market, particularly Linux. We believe that this competition from Linux will continue for the three months ending October 31, 2005 and future periods.

 

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 products was as follows:

 

 

 

Three Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

OpenServer revenue

 

$

4,309,000

 

(4

)%

$

4,496,000

 

Percent of products revenue

 

54

%

 

 

50

%

UnixWare revenue

 

2,085,000

 

(30

)%

2,984,000

 

Percent of products revenue

 

26

%

 

 

34

%

Other products revenue

 

1,559,000

 

8

%

1,449,000

 

Percent of products revenue

 

20

%

 

 

16

%

 

 

 

 

Nine Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

OpenServer revenue

 

$

12,987,000

 

(9

)%

$

14,278,000

 

Percent of products revenue

 

56

%

 

 

53

%

UnixWare revenue

 

6,606,000

 

(20

)%

8,240,000

 

Percent of products revenue

 

29

%

 

 

30

%

Other products revenue

 

3,502,000

 

(23

)%

4,538,000

 

Percent of products revenue

 

15

%

 

 

17

%

 

OpenServer revenue for the three and nine months ended July 31, 2005 decreased compared to the three months ended July 31, 2004 and this decrease was primarily attributable to continued competition. UnixWare revenue for the three and nine months ended July 31, 2005 was lower than the three and nine months ended July 31, 2004 primarily as a result of decreased project business. The increase in other products revenue from the three months ended July 31, 2005 compared to the three months ended July 31, 2004 was primarily attributable to the recognition of certain previously deferred amounts for upgrade revenue that were recognized upon the release and shipment of OpenServer 6.  The decrease in other products revenue for the nine months ended July 31, 2005 compared to the nine months ended July 31, 2004 was primarily attributable to decreased maintenance sales.

 

31



 

SCOsource Licensing Revenue

 

 

 

Three Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

SCOsource licensing revenue

 

$

32,000

 

(95

)%

$

678,000

 

Percent of total revenue

 

0

%

 

 

6

%

 

 

 

Nine Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

SCOsource licensing revenue

 

$

132,000

 

(81

)%

$

709,000

 

Percent of total revenue

 

0

%

 

 

2

%

 

We initiated our SCOsource business for the purpose of protecting our intellectual property rights in our UNIX source code and derivative works. SCOsource licensing revenue was $32,000 in the three months ended July 31, 2005 compared to revenue of $678,000 generated in the three months ended July 31, 2004. SCOsource licensing revenue was $132,000 in the nine months ended July 31, 2005 compared to revenue of $709,000 in the nine months ended July 31, 2004. Our SCOsource licensing revenue was primarily generated from the sales of SCO IP agreements. During the three and nine months ended July 31, 2004 we entered into one large transaction with a customer for a total of $500,000.

 

We are unable to predict the amount and timing of future SCOsource licensing revenue, and when generated, the revenue will be sporadic.

 

Services Revenue

 

 

 

Three Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

Services revenue

 

$

1,368,000

 

(14

)%

$

1,598,000

 

Percent of total revenue

 

15

%

 

 

14

%

 

 

 

Nine Months Ended July 31,

 

 

 

2005

 

Change

 

2004

 

 

 

 

 

 

 

 

 

Services revenue

 

$

4,249,000

 

(14

)%

$

4,969,000

 

Percent of total revenue

 

16

%

 

 

15

%

 

Services revenue consists primarily of technical support fees, engineering services fees, professional services and consulting fees, and education fees. These fees are typically charged and invoiced separately from UNIX products sales. The decrease in services revenue of $230,000, or 14 percent, from the three months ended July 31, 2004 as compared to the three months ended July 31, 2005 and the decrease in services revenue of $720,000, or 14 percent, from the nine months ended July 31, 2004 as compared to the nine months ended July 31, 2005, was in part due to the decrease in products revenue, fewer customers renewing services agreements and a decrease in professional services revenue.

 

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 to renew annual support and services agreements with existing UNIX customers.

 

32



 

Cost of Products Revenue

 

 

 

Three Months Ended July 31,

 

 

 

2005

 

Change

 

2004