10-K 1 a06-2250_110k.htm ANNUAL REPORT PURSUANT TO SECTION 13 AND 15(D)

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

 

(Mark One)

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

 

For the fiscal year ended October 31, 2005

 

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 of incorporation)

 

(I.R.S. Employer
Identification No.)

 

 

 

355 South 520 West

 

 

Lindon, Utah 84042

 

(801) 765-4999

(Address of principal executive

 

(Registrant’s telephone

offices, including zip code)

 

number, including area code)

 

 

 

Securities pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

 

 

 

Title of Each Class

Common Stock, par value $0.001 per share

Preferred Stock Purchase Rights

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES o  NO ý

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  YES o  NO ý

 

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference on Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the Registrant is a large accelerated filer, accelerated filer, or a non-accelerated filer.  See definition of ‘large accelerated filer and accelerated filer’ in Rule 12b-2 of the Exchange Act.  (Check one):  Large Accelerated Filer o Accelerated filer o Non-accelerated Filer 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

 

The aggregate market value of the common stock held by non-affiliates of the Registrant was approximately $35,155,000 based on the reported last sale price of common stock on April 30, 2005, which is the last business day of the Registrant’s most recently completed second fiscal quarter.

 

The number of shares of the Registrant’s common stock outstanding as of January 20, 2006, was 20,994,219.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s proxy statement to be filed pursuant to Regulation 14A in connection with its 2006 annual meeting of stockholders are incorporated by reference into Part III of this Form 10-K.

 

 



 

PART I.

 

 

Item 1.

Business

 

Item 1A.

Risk Factors

 

Item 1B.

Unresolved Staff Comments

 

Item 2.

Properties

 

Item 3.

Legal Proceedings

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

 

 

 

PART II.

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Item 6.

Selected Financial Data

 

Item 7.

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

 

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

 

Item 8.

Financial Statements and Supplementary Data

 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

Item 9A.

Controls and Procedures

 

Item 9B.

Other Information

 

 

 

 

PART III.

 

 

Item 10.

Directors and Executive Officers of the Registrant

 

Item 11.

Executive Compensation

 

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

Item 13.

Certain Relationships and Related Transactions

 

Item 14.

Principal Accounting Fees and Services

 

 

 

 

PART IV.

 

 

Item 15.

Exhibits and Financial Statement Schedules

 

Signatures

 

 

 

 

 

 

 

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PART I

 

Item 1.  Business

 

The Business section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain forward-looking statements relating to our business and strategy.  These forward-looking statements involve risks and uncertainties.  Many forward-looking statements are located in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of this Form 10-K.  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 in the section entitled “Risk Factors” under Part I, Item 1A of this Form 10-K. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

 

As used in the Form 10-K, “SCO,” and “OpenServer” are trademarks or registered trademarks of our Company in the United States and other countries.  “UNIX” and “UnixWare” are registered trademarks of The Open Group in the United States and other countries.  All other brand or product names are or may be trademarks of, and are used to identify the products and services of, their respective owners.  As used herein, the “Company” or “us,” “we,” “ours,” or similar terms refer to The SCO Group, Inc. and our operating subsidiaries.

 

Overview

 

We own the UNIX operating system and are a provider of UNIX-based products and services.  Our core business is to sell and service our UNIX software products to small-to-medium sized businesses and franchisees or branch offices of Fortune 1000 businesses.  Our most significant products that drive the majority of our UNIX revenue are OpenServer and UnixWare.  We intend to continue our UNIX research and development efforts during the year ending October 31, 2006 while at the same time investing in Me Inc., a growing suite of mobility services for personal and professional productivity.

 

We developed our SCOsource business as part of our ongoing efforts to establish and protect our intellectual property rights, particularly relating to our ownership of the UNIX source code.  In reviewing our intellectual property rights during the year ended October 31, 2003, we became aware that parts of, or modifications made to, our proprietary UNIX source code and derivative works have been included in the Linux operating system without our authorization or appropriate copyright attribution.

 

In March 2003, we filed a complaint against International Business Machines Corporation (“IBM”), alleging, in part, that IBM had breached its license agreement with us by, among other things, inappropriately contributing UNIX source code and derivative works to the open source community and seeking to use its knowledge and methods related to UNIX source code and derivative works and modifications licensed to it to decrease the value of the UNIX operating system in favor of promoting the Linux operating system, of which it has been a major backer.  Based on these alleged breaches, we delivered to IBM notice of termination of our license agreement with IBM that permitted IBM’s use of our UNIX source code in developing its AIX operating system.

 

In addition to our action against IBM, we have filed other complaints against such companies as Novell, Inc. (“Novell”), AutoZone Inc. (“AutoZone”), and DaimlerChrysler Corporation (“DaimlerChrysler”).  We describe our legal actions against these parties and the general status of these cases below under Part I, Item 3 of this Form 10-K.

 

Historical Information

 

We originally incorporated as Caldera Systems, Inc., a Utah corporation (“Caldera Systems”), in August 1998, and reincorporated as a Delaware corporation in March 2000, when we completed an initial public offering of our common stock.  In May 2001, we formed a new holding company in Delaware

 

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under the name of Caldera International, Inc. (“Caldera International”) to acquire substantially all of the assets and operations of the server and professional services groups of The Santa Cruz Operation, which changed its name to Tarantella, Inc. and was subsequently acquired by Sun Microsystems, Inc. (“Sun”).  In connection with this acquisition, Caldera Systems became a wholly owned subsidiary of Caldera International.  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.  On May 16, 2003, our stockholders approved our corporate name change from Caldera International, Inc. to The SCO Group, Inc.

 

UNIX Business

 

Background

 

Our core business focus is to serve the needs of small-to-medium sized businesses and branch offices and franchisees of Fortune 1000 companies, by providing reliable, cost-effective UNIX software technology for distributed, embedded and network-based systems.  We also provide a full range of pre- and post-sale technical support for all of our products, primarily focusing on OpenServer and UnixWare.  Additionally, we provide UNIX-based technical support services and consulting services.

 

Our largest source of revenue for our core UNIX business is derived from our worldwide, indirect, leveraged channel of partners, which includes distributors and independent solution providers (collectively, “resellers”).  We have resources, employees or contractors in a number of countries that provide support and services to resellers and end-user customers in those geographic areas.  The other principal channel for selling and marketing our products is through large corporations, which have a large number of branch offices or franchisees.  We access these corporations through their information technology or purchasing departments.  In addition, we also sell our UNIX products to original equipment manufacturers (“OEMs”).

 

The UNIX operating system, which we own, was conceived on the premise that an operating system should be easily adapted to a broad range of hardware platforms and should provide a simple way of developing programs.  Over the years, the UNIX operating system has been adapted for almost every OEM’s hardware architecture, and today UNIX has achieved the goal of seamlessly sharing data across heterogeneous environments.  We own a broad and deep set of intellectual property rights relating to the UNIX operating system, which we intend to continue to enforce and protect through our SCOsource business.

 

UNIX has had a long history of business implementation, and has a large and loyal base of both customers and vendors that provides solutions and applications.  On the Intel platform, our OpenServer and UnixWare products represent a low-cost UNIX operating system available for businesses.  Our UNIX product offerings allow our customers to take advantage of the reliability of UNIX at a relatively low cost.

 

Current Status and Strategy

 

Sales of our UNIX-based products and services have been declining over the last several years.  This decline in revenue has been primarily attributable to significant competition from alternative operating systems, particularly Linux.

 

We anticipate that our OpenServer and UnixWare products will continue to provide a future revenue stream for our UNIX business.  Unless there is a change in the current operating system environment, we expect revenue from these products will continue to decline.  Both of these UNIX products have a strong and loyal existing customer base of small-to-medium businesses and enterprise customers and constitute a well-known brand with a reputation for quality and reliability.

 

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We also have a seasoned, mature sales channel of resellers focused on the small-to-medium sized business market.  This channel is a unique asset that should allow us to continue to provide reliable UNIX operating systems for small-to-medium sized business customers.

 

During the year ended October 31, 2005, we released OpenServer 6, a major upgrade to our existing OpenServer product line and maintained our UnixWare product.  During the year ending October 31, 2006, we plan to focus certain UNIX development resources on augmenting our current UNIX products and our application products.  In addition, we have deployed engineering resources on Me Inc., a growing suite of mobility services for personal and professional productivity.  Me Inc. digital services will enable easy, secure, real-time mobile access to all kinds of information stored in enterprise and web-based systems without the need for direct connection between end-point devices and those systems.  We anticipate releasing various Me Inc. digital services and a development toolkit during the first half of calendar year 2006.

 

Our research and development efforts are described in more detail below in the subsection entitled “Software Engineering and Development.”

 

Competition

 

We face direct competition in the operating system market from Linux operating system providers, other non-UNIX operating system providers and other UNIX-based operating system providers.  In the operating system market, some of our competitors include IBM, Red Hat Inc. (“Red Hat”), Novell, Hewlett-Packard (“HP”), Microsoft Corporation (“Microsoft”), and Sun.  Operating systems, primarily Linux, are aggressively taking market share away from UNIX and our UNIX revenue has declined over the last several years.

 

We believe that we compete favorably with many of our competitors in a number of respects, including product performance, functionality and price and networking capability.  Notwithstanding these factors, our revenue has declined over the last several years.  Many of our competitors are significantly larger than we are and have much greater access to funding, technical expertise, marketing, and research and development.  In addition, many of our competitors have established brand recognition and market presence that may prevent us from obtaining or retaining significant market share.  Additionally, the assertion of our legal rights relating to our UNIX ownership and related copyrights and our other legal actions has resulted in us becoming the focus of a significant amount of negative publicity from various sources that has to some degree, hampered our ability to compete favorably.

 

The success of our UNIX business will, in large measure, depend on the level of commitment and certification we receive from industry partners and developers.  In recent years, we have seen hardware and software vendors as well as software developers turn their certification and application development efforts toward Linux and elect not to continue to support or certify to our UNIX operating system products.  This trend continued for the year ended October 31, 2005, and we believe that it will continue during the year ending October 31, 2006.  If this trend does continue as expected, our competitive position will be adversely impacted and our future revenue from our UNIX business will decline, possibly at an even faster rate than it has declined over the last several years.  The decline in our UNIX business may be accelerated if industry partners withdraw their support from us as a result of our SCO Litigation.

 

Products and Services

 

OpenServer.  OpenServer is our UNIX-based offering targeted at small-to-medium businesses.  Businesses use OpenServer to simplify and speed business operations, better understand and respond to their customers’ needs and achieve a competitive advantage.  OpenServer excels at running multi-user, transaction and business applications, communications gateways, and mail and messaging servers in both host and client/server environments.  We continue to aggressively support existing users of

 

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OpenServer, keeping the operating system current with hardware platforms available in the market.  The latest release, OpenServer 6, began shipping in June 2005.

 

UnixWare.  UnixWare is our UNIX-based offering targeted at medium-size businesses and enterprise customers.  UnixWare is an advanced deployment platform for industry standard Intel processor systems.  UnixWare is a foundation for solutions where proven scalability, reliability and affordability are critical.  UnixWare includes enhancements and refinements to the UNIX platform, representing significant added value for existing UnixWare customers.  The latest release of UnixWare, UnixWare 7.1.4, began shipping in May 2004.

 

Other Products.  In addition to the OpenServer and UnixWare, we offer product maintenance and additional UNIX-related products.

 

Technical Support Services.  We provide a full range of pre- and post-sale technical support for all of our products, primarily focusing on OpenServer and UnixWare.

 

We also provide technical support to our partners, including resellers, hardware and software vendors and solution providers, as well as directly supporting our end-user customers.  Our partners have the option to direct their customers to us for technical support or to provide first-level customer support themselves and utilize our technical expertise for second-tier support.

 

Technical support services include a range of options from single incident email and telephone support to dedicated “enterprise” level support agreements.  Customers seeking additional technical support directly from us may enter into service agreements that best suit their needs.

 

Other Services.  Our other services include software development and programming, migration tools and services and assisting customers with modernizing and integrating legacy applications with web services.  We assist our end-user customers and solution providers in planning, creating, implementing and deploying business application solutions.

 

Strategic Alliances

 

We have business alliances with a number of key global industry partners.  These relationships encompass product integration, two-way technology transfers, product certification, channel partnerships and revenue generating initiatives in areas of product bundling, OEM agreements and training and education.  The objectives of these partnerships include providing complete hardware and software UNIX solutions and mutually developing our sales and distribution channel by coordinating marketing initiatives in creating demand for our products.  We also have alliances with a number of solution providers who write and develop custom applications to run on UNIX operating systems.  Most of our small business customers that cannot afford high-end solutions or an information technology staff rely on one of our channel partners for these services.  Maintaining these strategic alliances for the year ending October 31, 2006 will be critical to the success of our UNIX business, and in particular, to the success of our recently released version of OpenServer.  We intend to continue to keep relationships with key partners in certain vertical markets such as retail, medical/pharmaceutical, manufacturing and accounting where our UNIX operating systems have an existing presence.  Our efforts to maintain or expand industry partnerships may be adversely impacted by our SCO Litigation.

 

Sales and Marketing

 

Our UNIX sales and marketing or field operations are organized by geographic area:  our Americas division and our International division.  Each division includes a sales organization, field marketing, pre- and post-sales technical support, and local professional services personnel.

 

Americas.  The Americas team has field sales and support personnel located around the United States, Latin America and Canada.  This region delivered approximately 52% of the total UNIX revenue

 

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for the year ended October 31, 2005.  The sales team is organized into Area Sales Managers (“ASMs”), who each manage a specific geographic area and support our resellers and channel partners as well as service our corporate account customer base, including OEM partners.  ASMs have the following specific roles:

 

                  Channel Sales – ASMs manage our relationships with our resellers and vertical solution providers.  Resellers sell numerous solutions to small business customers in their geographic territory.  Vertical solution providers provide bundled applications to specific vertical markets, which include retail point of sale, manufacturing, accounting and medical/pharmaceutical.  Many of our resellers and vertical solution providers purchase operating system platform products directly from us.  In order to efficiently support the thousands of smaller resellers and vertical solution providers, we contract with several major distributors in a two-tier distribution model.

 

                  Corporate Sales – ASMs also sell directly to our major corporate accounts with branch offices or franchisees and other large corporations.  Typically, these customers have an existing suite of third-party or internally developed applications designed to run on our dependable and scalable OpenServer or UnixWare operating systems.  In many cases, our operating system and the applications are then deployed in an identical fashion across thousands of branch offices or franchisees.

 

International.  The International region delivered approximately 48% of our UNIX revenue for the year ended October 31, 2005 and includes EMEA (Europe, the Middle East and Africa) and Asia Pacific.  We have resources, employees or contractors in the United Kingdom, Germany, France, Italy, Spain, China, Korea, India, Japan, Australia and Taiwan.

 

The country sales teams perform the same functions as the Americas sales team, including channel sales, corporate account sales and OEM sales.  In the International division, particularly in smaller countries, one sales representative will manage both channel and major account sales within that country.  The International division also uses local distributors in each location to process all channel orders.

 

We consider our indirect sales channel one of our most valuable assets.  In addition to the current revenue this channel produces, our reseller partners are valuable for the influence they possess on the purchasing decisions of small businesses.  Our resellers are often not only the primary point of contact for their small businesses customers’ purchasing decisions, but their customers’ outsourced information technology department.  The reach of our network of resellers into the small business community is broad as evidenced by our large install base of servers running various versions of our OpenServer and UnixWare operating systems.  A key to our future success will be our ability to provide additional products and services to our reseller channel and to communicate our product and corporate strategy to these resellers.

 

Our marketing efforts support our sales and distribution efforts, promotions and product introductions, and include marketing activities to promote our UNIX products.  Pull marketing is focused on branding, solutions, advertising, tradeshows, press releases, white papers and marketing literature.  In particular, our marketing strategy consists of:

 

                  branding our UNIX products through public relations and advertising activities;

 

                  creating an effective partner program to generate brand awareness and promote our UNIX products; and

 

                  increasing public awareness of our UNIX products by participating in strategic tradeshows, conferences and technology forums.

 

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Information regarding financial data by segments, geographic regions and long-lived assets is set forth in Part II, Item 8 of this Form 10-K in Note 15 to the consolidated financial statements.

 

Software Engineering and Development

 

We have taken steps to improve our UNIX software products to maintain system reliability, maintain backward compatibility, increase application support, provide broad hardware support, better integrate widely used internet applications, improve usability, and increase system performance.  While we believe that these product enhancements will extend the lives and improve the functionality of our UNIX products, they will not result in significant revenue increases in the short-term due to the long adoption cycle for new operating system purchases and the length of our operating system product sales cycle.

 

Technology trends in the central processing unit (“CPU”) market have enabled our 32-bit operating systems and associated applications to run on 64-bit hardware.  These developments have significantly reduced the entry cost into the 64-bit market.  We have assigned a limited, but skilled set of resources to develop a 64-bit version of our operating system technology.  Our objective in making this investment is to provide our current and new customers a long-term product roadmap that will provide them a seamless upgrade path to 64-bit computing.  We expect this investment to provide future returns as we give customers confidence in their commitment to our technologies.

 

We are also deploying engineering resources on Me Inc., a growing suite of mobility services for personal and professional productivity, as well as custom services for business, government and consumer users.  Me Inc. digital services will enable easy, secure, real-time mobile access to all kinds of information stored in enterprise and web-based systems without the need for direct connection between end-point devices and those systems.

 

Our product development process is modeled to standard, commercial software engineering practices and we apply these practices to ensure consistent product quality.  As a result, we are able to offer our platform products to OEM customers in several configurations without significant additional effort.  We have incurred $8,329,000, $10,612,000, and $11,012,000 in research and development expense during the years ended October 31, 2005, 2004, and 2003, respectively.

 

SCOsource Business

 

Background

 

We acquired our rights relating to the UNIX source code and derivative works and other intellectual property rights when we purchased substantially all of the assets and operations of the server and professional services groups of The Santa Cruz Operation, Inc. in May 2001.  The Santa Cruz Operation had previously acquired such UNIX source code and other intellectual property rights from Novell in 1995, which technology was initially developed by AT&T Bell Labs.  Through this process, we acquired all UNIX source code, source code license agreements with thousands of UNIX vendors, certain UNIX intellectual property, all claims for violation of the above mentioned UNIX licenses and copyrights and other claims, and the control over UNIX derivative works.  The UNIX licenses we obtained have led to the development of several proprietary UNIX-based operating systems, including but not limited to our own UnixWare and OpenServer products, IBM’s AIX, Sequent’s DYNIX/Ptx, Sun’s Solaris, SGI’s IRIX and Hewlett-Packard’s HPUX.  These operating systems are all derivatives of the original UNIX source code owned by us.

 

The success of our SCOsource business depends on our ability to protect and enforce our rights to proprietary UNIX source code, copyrights and other intellectual property rights.  To protect our proprietary rights, we rely primarily on a combination of copyright laws, contractual rights and an aggressive legal strategy.

 

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During the year ended October 31, 2003, we commenced our first SCOsource initiative in which we began reviewing the status of our existing UNIX license agreements with UNIX vendors and to identify those in the software industry that may be using our intellectual property without obtaining the necessary licenses.  As part of this process, we became aware that parts of our proprietary UNIX source code and derivative works had been included in the Linux operating system without attribution or our authorization in violation of our intellectual property rights.  We filed a complaint against IBM in March 2003 alleging that IBM breached its license agreement with us related to its efforts to promote and support the Linux operating system.  In addition to our action against IBM, we have filed other complaints against Novell, AutoZone, and DaimlerChrysler.  In our litigation with Novell, we seek relief for, among other things, Novell’s alleged bad faith efforts to interfere with our ownership and enforcement of our copyrights related to our UNIX source code.  A related lawsuit was filed against us by Red Hat.  We describe our legal actions in more detail below under Part I, Item 3 of this Form 10-K.

 

In August 2003, we offered to Linux and other end users a license to use our UNIX intellectual property.  The SCOsource intellectual property (“IP”) license permits the use of our UNIX intellectual property, in binary form only, as contained in the Linux operating system.  By purchasing the license, customers will properly compensate us for our UNIX intellectual property as currently found in Linux.  The SCOsource IP license was created in response to requests to provide a licensing program for those in the industry using our UNIX intellectual property to allow them to continue to run their mission-critical business solutions running in other environments.

 

Intellectual Property Protection

 

Our intellectual property protection relies primarily on a combination of contract rights, copyright laws and an aggressive legal strategy.  We also require that our employees and consultants sign confidentiality and nondisclosure agreements.  We also regulate access to, and distribution of, our documentation and other proprietary information.

 

We cannot guarantee the success of our SCO Litigation and other efforts to protect and enforce our intellectual property rights, but we will continue to seek to enforce and pursue these rights through the judicial system.  Additionally, we cannot be certain that we will succeed in preventing the future misappropriation of our proprietary information including copyrights and other intellectual property rights or that we will be able to prevent the unauthorized future use of our technology.

 

Employees

 

As of October 31, 2005, we had a total of 166 full-time equivalent employees.  Of the total employees, 49 were in product development, 55 in sales and marketing, 21 in customer service and technical support, 10 in customer delivery and manufacturing, 3 in SCOsource and 28 in administration (which includes finance, human resources, executive management and information systems).  From time to time, we also engage independent contractors to support our professional services, product development, sales and marketing organizations.  Our employees are not represented by any labor union and are not subject to a collective bargaining agreement, and we have never experienced a work stoppage.  In general, we believe our relations with our employees are good.

 

Item 1A.  Risk Factors

 

Because of the following factors, as well as other variables affecting our operating results, past financial performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods.

 

We do not have a history of profitable operations.

 

Our year ended October 31, 2003 was the first full year we were profitable in our operating history.  Our profitability for the year ended October 31, 2003 resulted primarily from our SCOsource

 

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business.  For the years ended October 31, 2005 and 2004, we incurred net losses to common stockholders of $10,726,000 and $16,227,000, respectively, and our accumulated deficit as of October 31, 2005 was $234,942,000.

 

If our revenue from the sale of our UNIX products and services continues to decline, we will need to further reduce operating expenses to generate positive cash flow. We may not be able to further reduce operating expenses without damaging our ability to support our existing UNIX business. Additionally, we may not be able to achieve profitability through additional cost-cutting actions.

 

Our UNIX products and services revenue has declined over the last several years primarily as a result of continued competition from alternative operating systems, particularly Linux. In our results of operations, we recognize revenue from agreements for support and maintenance contracts and other long-term contracts that have been previously invoiced and are included in deferred revenue. Our future UNIX revenue may be adversely impacted and may continue to decline if we are unable to replenish these deferred revenue balances with long-term maintenance and support contracts or replace them with other sustainable revenue streams. If we are unable to generate positive cash flow and profitable operations, our business will be adversely impacted.

 

We may not prevail in our SCO Litigation, which may adversely affect our ability to continue in business.

 

We continue to pursue the SCO Litigation and believe in the merits of our cases.  In our action against IBM, we seek damages for claims generally relating to our allegation that IBM has inappropriately used and distributed our UNIX source code and derivative works in connection with its efforts to promote the Linux operating system.  IBM has responded to our claims and brought counterclaims against us asserting generally that we do not have the right to assert claims based on our ownership of UNIX intellectual property against IBM or others in the Linux market.  Discovery is continuing in the case.  If we do not prevail in our action against IBM, or if IBM is successful in its counterclaims against us, our business and results of operations would be materially harmed and we may not be able to continue in business.  The litigation with IBM and others will be costly, and our costs for legal fees and related expenses have been and will continue to be substantial and may exceed our capital resources.  Additionally, the market price of our common stock may be negatively affected as a result of developments in our legal action against IBM that may be, or may be perceived to be, adverse to us.

 

As a result of the SCO Litigation, participants in the Linux marketplace and others affiliated with IBM or sympathetic to the Linux movement have taken actions attempting to negatively affect our business and our SCOsource efforts.  Linux proponents have taken a broad range of actions against us, including, for example, attempting to influence participants in the markets in which we sell our products to reduce or eliminate the amount of our products and services they purchase from us.  We expect that similar efforts likely will continue.  There is a risk that additional participants in our marketplace will negatively view the SCO Litigation, and we may lose support from such participants.  Any of the foregoing could adversely affect our position in the marketplace, our results of operations and our stock price and our ability to stay in business.

 

As a response to our claim that our UNIX source code and derivative works have inappropriately been included in Linux, Novell has publicly asserted its belief that it owns certain copyrights in our UNIX source code, and it has filed 15 copyright applications with the United States Copyright Office related to UNIX.  Novell has claimed to have retained rights related to UNIX source code licenses, including the license with IBM.  Novell asserts it has the right to take action on behalf of SCO in connection with such licenses, including termination rights.  Novell has purported to veto our termination of the IBM, Sequent and SGI licenses.  We have asserted that we obtained the UNIX business, source code, claims and copyrights when we acquired the assets and operations of the server and professional services groups from The Santa Cruz Operation in May 2001, which had previously acquired all such assets and rights from Novell in 1995 pursuant to an asset purchase agreement, as amended.  In January 2004, in response

 

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to Novell’s actions, we brought suit against Novell for slander of title seeking relief for Novell’s alleged bad faith effort to interfere with our rights related to our UNIX source code and derivative works and our UnixWare products.  Novell twice unsuccessfully sought to have the case dismissed.

 

On July 29, 2005, Novell filed its Answer and Counterclaims against us, asserting counterclaims for our alleged breaches of the Asset Purchase Agreement between Novell and our predecessor-in-interest, The Santa Cruz Operation, Inc., for slander of title, restitution/unjust enrichment, and accounting, and for declaratory relief regarding Novell’s alleged rights under the Asset Purchase Agreement.  On or about December 30, 2005, we filed a motion for leave to amend our complaint to assert additional claims against Novell, including copyright infringement, unfair competition and a breach of Novell’s limited license to use our UNIX source code.

 

Notwithstanding our assertions of full ownership of critical UNIX-related intellectual property rights, as set forth above, including copyrights, and even if we are successful in our legal action against Novell and end users such as AutoZone and DaimlerChrysler, the efforts of Novell and the other Linux proponents described above may cause further damage to our business including our ability to monetize our UNIX assets.  These efforts of Linux proponents also may increase the negative view some participants in our marketplace have regarding our SCO Litigation and may contribute to creating confusion in the marketplace about the validity of our claim that the unauthorized use of our UNIX source code and derivative works in Linux violates our contracts and copyrights.  Increased negative perception and potential confusion about our claims in our marketplace could impede our continued pursuit of the SCO Litigation and negatively impact our business.  For example, we believe that our decrease in SCOsource revenue for the years ended October 31, 2005 and 2004 was in part attributable to Novell’s claim of UNIX copyright ownership, which may have caused potential customers to delay or forego licensing until an outcome in this legal matter has been reached.

 

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

 

In the operating system market, our competitors include IBM, Red Hat, Novell, HP, Sun, Microsoft and other Linux distributors.  These and other competitors are aggressively pursuing the current UNIX operating system market. Many of these competitors have access to substantially greater resources than we do.  The major competitive alternative to our UNIX products is Linux.  The expansion of our competitors’ offerings may restrict the overall market available for our UNIX products, including some markets where we have been successful in the past.

 

Our future success may depend in part on our ability to continue to meet the increasing needs of our customers by supporting existing and emerging technologies.  If we do not enhance our products to meet these evolving needs, we may not remain competitive and be able to sustain or grow our business. Additionally, because technological advancement in the UNIX operating system market and alternative operating system markets is progressing at an advanced pace, we will have to develop and introduce enhancements to our existing products and any new products on a timely basis to keep pace with these developments, evolving industry standards and changing customer requirements.  Our failure to meet any of these and other competitive pressures may render our existing products and services obsolete, which would have an adverse impact on our revenue and operations.

 

The success of our UNIX business will depend on the level of commitment and certification we receive from industry partners and developers.  In recent years, we have seen hardware and software vendors as well as software developers turn their certification and application development efforts toward Linux and elect not to continue to support or certify to our UNIX operating system products.  If this trend continues, our competitive position will be adversely impacted and our future revenue from

 

11



 

our UNIX business will decline.  The decline in our UNIX business may be accelerated if industry partners withdraw their support from us for any reason, including our SCO Litigation.

 

If the market for UNIX continues to contract, our business will be harmed.

 

Our revenue from the sale of UNIX products has declined over the last several years.  This decrease in revenue has been attributable primarily to increased competition from other operating systems, particularly Linux.  Our sales of UNIX products and services are primarily to existing customers. If the demand for UNIX products continues to decline, and we are unable to develop UNIX products and services that successfully address a market demand, our UNIX revenue will continue to decline, industry participants may not certify to our operating system and products, we may not be able to attract new customers or retain existing customers and our business and results of operations will be adversely affected.  Because of the long adoption cycle for operating system purchases and the long sales cycle of our operating system products, we may not be able to reverse these revenue declines quickly.

 

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

 

The decline in our UNIX business and our SCO Litigation may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products.  This would lead to an accelerated decline in our UNIX products and services revenue and would adversely impact our results of operations and liquidity.

 

Our claims relating to our UNIX intellectual property may subject us to additional legal proceedings.

 

In August 2003, Red Hat brought a lawsuit against us asserting that the Linux operating system does not infringe on our UNIX intellectual property rights and seeking a declaratory judgment for non-infringement of copyrights and no misappropriation of trade secrets.  In addition, Red Hat claims we have engaged in false advertising in violation of the Lanham Act, deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, and trade libel and disparagement.  Although this case is currently stayed pending the resolution of our suit against IBM, we intend to vigorously defend this action.  However, if Red Hat is successful in its claim against us, our business and results of operations could be materially harmed.

 

In addition, regulators or others in the Linux market and some foreign regulators have initiated or in the future may initiate legal actions against us, all of which may negatively impact our operations and future operating performance.

 

We rely on our indirect sales channel for distribution of our products, and any disruption of our channel at any level could adversely affect the sales of our products.

 

We have a two-tiered distribution channel.  The relationships we have developed with resellers allow us to offer our products and services to a much larger customer base than we would otherwise be able to reach through our own direct sales and marketing efforts.  Some solution providers also purchase solutions through our resellers, and we anticipate they will continue to do so.  Because we usually sell indirectly through resellers, we cannot control the relationships through which resellers, solution providers or equipment integrators purchase our products.  In turn, we do not control the presentation of our products to end users.  Therefore, our sales could be affected by disruptions in the relationships between us and our resellers, between our resellers and solution providers, or between solution providers and end users.  Also, resellers and solution providers may choose not to emphasize our products to their customers.  Any of these occurrences could diminish the effectiveness of our distribution channel and lead to decreased sales.

 

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Our future SCOsource licensing revenue is uncertain.

 

We initiated the SCOsource licensing effort in the year ended October 31, 2003 to review the status of UNIX licensing and sublicensing agreements.  This effort resulted in the execution of two significant vendor license agreements and generated $25,846,000 in revenue during the year ended October 31, 2003.  During the year ended October 31, 2004, our SCOsource licensing revenue declined significantly to only $829,000 and during the year ended October 31, 2005, our SCOsource licensing revenue declined further to $166,000.  Because of a lack of historical experience and the uncertainties related to SCOsource licensing revenue, we are unable to estimate the amount and timing of future SCOsource licensing revenue, if any.  If we do receive revenue from this source, it may be sporadic and fluctuate from quarter to quarter.  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.

 

Fluctuations in our operating results or the failure of our operating results to meet the expectations of public market analysts and investors may negatively impact our stock price.

 

Fluctuations in our operating results or our failure to meet the expectations of analysts or investors, even in the short-term, could cause our stock price to decline significantly.  Because of the potential for significant fluctuations in our SCOsource licensing revenue in any particular period, you should not rely on comparisons of our results of operations as an indication of future performance.

 

Factors that may affect our results include:

 

                                          ability to successfully negotiate and complete licensing and other agreements related to our intellectual property;

 

                                          the interest level of resellers in recommending our UNIX business solutions to end users and the introduction, development, timing, competitive pricing and market acceptance of our products and services and those of our competitors;

 

                                          the activities of short sellers;

 

                                          changes in general economic conditions, such as recessions, that could affect capital expenditures in the software industry;

 

                                          results of, or developments in, our SCO Litigation;

 

                                          changes in business attitudes toward UNIX as a viable operating system compared to other competing systems, especially Linux;

 

                                          the contingency and other legal fees we may pay to the law firms representing us in our efforts to establish our intellectual property rights; and

 

                                          changes in attitudes of customers and partners due to the decline in our UNIX business and our aggressive position against the inclusion of our UNIX code and derivative works in Linux.

 

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

 

As a result of the factors listed above and elsewhere, it is possible that our results of operations may be below the expectations of public market analysts and investors in any particular period.  This could cause our stock price to decline. If revenue falls below our expectations, and we are unable to

 

13



 

quickly reduce our spending in response, our operating results will be lower than expected. Our stock price may fall in response to these events.

 

Our foreign-based operations and sales create special problems, including the imposition of governmental controls and taxes and fluctuations in currency exchange rates that could hurt our results.

 

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

 

                                          potential loss of developed technology through piracy, misappropriation, or more lenient laws regarding intellectual property protection;

 

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

 

                                          fluctuations in currency exchange rates and economic instability;

 

                                          longer payment cycles for sales in foreign countries; and

 

                                          seasonal reductions in business activity.

 

In addition, certain of our operating expenses are denominated in local currencies, creating risk of foreign currency translation losses that could harm our financial results and cash flows.  When we generate profits in foreign countries, our effective income tax rate is increased.

 

During the three months ended April 30, 2004, our Indian office was given a withholding tax assessment from the Government of India Income Tax Department.  The Tax Department assessed a 15 percent withholding tax on certain revenue transactions in India that the Tax Department deemed royalty revenue under the Income Tax Act. We have filed an appeal with the Tax Department and believe that revenue from our packaged software does not qualify for royalty treatment and therefore would not be subject to withholding tax.  However, we may be unsuccessful in our appeal against the Tax Department and be obligated to pay the assessed taxable amounts.  Because of our international operations, we may be subject to additional withholding or taxes from other international jurisdictions.

 

If we are unable to retain key personnel in an intensely competitive environment, our operations could be adversely affected.

 

We need to retain our key management, technical and support personnel.  Competition for qualified professionals in the software industry is intense, and departures of existing personnel could be disruptive to our business and might result in the departure of other employees.  The loss or departure of any officers or key employees could harm our ability to implement our business plan and could adversely affect our operations.  Our future success depends to a significant extent on the continued service and coordination of our management team, particularly Darl C. McBride, our President and Chief Executive Officer.

 

Our Engagement Agreement with the law firms representing us in the SCO Litigation requires us to pay for expert, consulting and other costs, which could harm our liquidity position if these costs are higher than anticipated.

 

As of October 31, 2005, we had a total of $10,437,000 in cash and cash equivalents and available-for-sale securities and an additional $2,875,000 of restricted cash to be used in our operations and pursue the SCO Litigation.  Since October 31, 2004, we have spent $2,125,000 for expert, consulting and other costs as agreed in the Engagement Agreement with our legal counsel in the SCO Litigation.  As we continue with discovery and other trial preparations during the year ending October 31, 2006, we believe

 

14



 

that we will spend the $2,875,000 remaining in escrow and we may be required to place additional amounts into the escrow account, which could harm our liquidity position.

 

We have issued options under our equity compensation plans without complying with registration or qualification requirements under the securities laws of California, Georgia and possibly other states, and, as a result, we may incur rescission liability for such options and may face additional potential claims under state securities laws.

 

In addition to the shares issued under the ESPP, we have granted options under our 1999 Omnibus Stock Incentive Plan and 2002 Omnibus Stock Incentive Plan without complying with the registration or qualification requirements under the securities laws of California, Georgia and possibly other states.  We may face rescission liability to plan participants holding unexercised stock options in these states.  Additionally, regulatory authorities may require us to pay fines or they may impose other sanctions upon us, and we may face other claims by plan participants other than rescission claims.

 

Our stock price is volatile.

 

The trading price for our common stock has been volatile during the last several years and our share price has changed dramatically over short periods.  We believe that changes in our stock price are affected by the factors mentioned above under the caption entitled “Fluctuations in our operating results or the failure of our operating results to meet the expectations of public market analysts and investors may negatively impact our stock price” as well as from changing public perceptions concerning the strength of our intellectual property claims and other factors beyond our control.  Public perception can change quickly and without any change or development in our underlying business or litigation position.  An investment in our stock is subject to such volatility and, consequently, is subject to significant risk.

 

There are risks associated with the potential exercise of our outstanding options.

 

As of December 31, 2005, we have issued and outstanding options to purchase up to approximately 3,811,000 shares of common stock with an average exercise price of $4.17 per share.  The existence of such rights to acquire common stock at fixed prices may prove a hindrance to our efforts to raise future equity and debt funding, and the exercise of such rights will dilute the percentage ownership interest of our stockholders and may dilute the value of their ownership.  The possible future sale of shares issuable on the exercise of outstanding options could adversely affect the prevailing market price for our common stock.  Further, the holders of the outstanding stock options may exercise them at a time when we would otherwise be able to obtain additional equity capital on terms more favorable to us.

 

Common stock available for resale may depress the market price of our common stock.

 

We have filed a registration statement with the Securities and Exchange Commission (“SEC”), which has been declared effective, covering the potential resale by one of our shareholders of up to 2,105,163 shares of common stock, or 10.0% of our outstanding common stock.  In addition, we have filed a registration statement with the SEC, which has not been declared effective, covering the potential resale by some of our shareholders of up to 2,852,449 shares of our common stock, or 13.6% of our outstanding common stock.  The existence of a substantial number of shares of common stock subject to immediate resale could depress the market price for our common stock and impair our ability to raise needed capital.

 

Our stock price could decline further because of the activities of short sellers.

 

Our stock has attracted significant interest from short sellers.  The activities of short sellers could further reduce the price of our stock or inhibit increases in our stock price.

 

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The right of our Board of Directors to authorize additional shares of preferred stock could adversely impact the rights of holders of our common stock.

 

Our Board of Directors currently has the right, with respect to the 5,000,000 shares of our preferred stock, to authorize the issuance of one or more additional series of our preferred stock with such voting, dividend and other rights as our directors determine.  The Board of Directors can designate new series of preferred stock without the approval of the holders of our common stock.  The rights of holders of our common stock may be adversely affected by the rights of any holders of additional shares of preferred stock that may be issued in the future, including without limitation, further dilution of the equity ownership percentage of our holders of common stock and their voting power if we issue preferred stock with voting rights.  Additionally, the issuance of preferred stock could make it more difficult for a third party to acquire a majority of our outstanding voting stock.

 

Our stockholder rights plan could make it more difficult for a hostile bid for our company or a change of control transaction to succeed at current market prices for our stock.

 

We have adopted a stockholder rights plan.  The power given to the Board of Directors by the stockholder rights plan may make it more difficult for a change of control of our company to occur or for our company to be acquired when the acquisition is opposed by our Board of Directors.

 

Item 1B.  Unresolved Staff Comments

 

Not applicable as we are not an accelerated filer or a well-known seasoned issuer.

 

Item 2.  Properties

 

We are headquartered in Lindon, Utah, where we lease administrative, sales and marketing facilities.  We lease additional facilities for administration, sales and marketing and product development in Scotts Valley, California and Murray Hill, New Jersey.  The leases for our facilities expire at various dates through our fiscal year ending October 31, 2008.

 

Our international field operations occupy leased facilities in France, Japan, Germany, India, and the United Kingdom.  The leases for these field operation facilities expire at various dates through our fiscal year ending October 31, 2008.

 

As indicated in Item 1, we have two business segments: UNIX and SCOsource.  These segments use substantially all of the properties, at least in part, and we retain the flexibility to use each of our properties in whole or in part for each of our segments.

 

We believe that our existing facilities are adequate to meet current business and operating requirements and that additional office space will be available to meet our needs if required.

 

Item 3.  Legal Proceedings

 

IBM Corporation

 

On or about March 6, 2003, we filed a civil complaint against IBM 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.  In this action we claim, among other things, that IBM breached its UNIX source code licenses (both the IBM and Sequent Computer Systems, Inc. “Sequent” licenses) by disclosing restricted information concerning the UNIX source code and derivative works and related information in connection with its efforts to promote the Linux operating system.  Our complaint includes, among other things, claims for breach of contract, unfair competition, tortious interference and copyright infringement.  As a result of IBM’s actions, we are requesting damages in an amount to be proven at trial and seeking injunctive relief.

 

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On or about March 6, 2003, we notified IBM that they were not in compliance with our UNIX source code license agreement and on or about June 13, 2003, we delivered to IBM a notice of termination of their UNIX source code license agreement, which underlies IBM’s AIX software.  On or about August 11, 2003 we sent a similar notice terminating the Sequent source code license.  IBM disputes our right to terminate those licenses.  In the event our termination of those licenses is valid we believe IBM is exposed to substantial damages and injunctive relief based on its continued use and distribution of the AIX operating system.  On June 9, 2003, Novell sent us a notice purporting to waive our claims against IBM regarding its license breaches.  We do not believe that Novell had the right to take any such action relative to our UNIX source code rights.

 

On February 27, 2004, we filed a second amended complaint which alleges nine causes of action that are similar to those set forth above, adds a new claim for copyright infringement and removes the claim for misappropriation of trade secrets.  IBM filed an answer and fourteen counterclaims.  Among other things, IBM has asserted that we do not have the right to terminate IBM’s UNIX license and IBM has claimed that we have breached the GNU General Public License and have infringed certain patents held by IBM.  IBM’s counterclaims include claims for breach of contract, violation of the Lanham Act, unfair competition, intentional interference with prospective economic relations, unfair and deceptive trade practices, promissory estoppel, patent infringement and a declaratory judgment claim for non-infringement of copyrights.  On October 6, 2005, IBM voluntarily dismissed with prejudice its claims for patent infringement.

 

On February 9, 2005, the Court denied three motions for partial summary judgment that IBM had filed on our contract claims, on IBM’s eighth counterclaim for copyright infringement, and on IBM’s tenth counterclaim for a declaration of non-infringement of our 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 our 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.

 

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.

 

Pursuant to the Court’s July 1, 2005 Scheduling Order, we filed our Interim Disclosure of Material Misused by IBM on October 28, 2005.  Our report includes a matrix that identifies 217 separate technology disclosures that we contend IBM improperly made to enhance Linux in violation of one or more contractual prohibitions governing IBM’s use of our proprietary material.  We continued to review relevant materials including evidence IBM has produced in discovery and filed an updated report on December 22, 2005 detailing IBM’s misuse of our proprietary material.  Our December 22 report includes 293 total disclosures which we claim violate our contractual rights and copyrights.  These reports and the disclosures identified are the result of analysis from experienced outside technical consultants.  Discovery is ongoing in the case as the parties prepare for trial.

 

Novell, Inc.

 

On January 20, 2004, we filed suit in Utah state court against Novell, Inc. for slander of title seeking relief for its alleged bad faith effort to interfere with our ownership of copyrights related to our UNIX source code and derivative works and our UnixWare product.  After removal to federal court, the case is now 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, we requested preliminary and permanent injunctive relief as well as damages.  Through these claims, we seek to require Novell to assign to us all copyrights that we believe Novell has wrongfully registered, prevent Novell from representing any ownership interest in those copyrights and require Novell to retract or withdraw all representations it has made regarding its purported ownership of those copyrights and UNIX itself.

 

17



 

Novell has filed two motions to dismiss claiming, among other things, that Novell’s false statements were not uttered with malice and are privileged under the law.  The Court denied both of Novell’s motions to dismiss.  On July 29, 2005, Novell filed its Answer and Counterclaims against us, asserting counterclaims for our alleged breaches of the Asset Purchase Agreement between Novell and our predecessor-in-interest, The Santa Cruz Operation, Inc., for slander of title, restitution/unjust enrichment, and accounting, and for declaratory relief regarding Novell’s alleged rights under the Asset Purchase Agreement.  On December 6, 2005, a scheduling order was entered by the Court setting a schedule of discovery and motions leading up to a trial in June 2007.  On or about December 30, 2005, we filed a motion for leave to amend our complaint to assert additional claims against Novell including copyright infringement, unfair competition and a breach of Novell’s limited license to use our UNIX code.  Novell has consented to our filing of these additional claims.  Discovery is commencing in the case.

 

DaimlerChrysler Corporation

 

On or about March 3, 2004, we brought suit against DaimlerChrysler Corporation for its alleged violations of its UNIX license agreement with us. 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 we 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 us 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, we filed a motion to stay the case pending the clarification of certain issues in the IBM litigation. The Court denied the motion to stay and based on a stipulation of the parties, the Court signed an order of dismissal without prejudice.  The Appellate Court has dismissed our appeal of the July 21, 2004 ruling finding that the order was not a final, appealable order.

 

AutoZone, Inc.

 

On or about March 2, 2004, we brought suit against AutoZone, Inc. for its alleged violations of our UNIX copyrights through its use 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 our 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.

 

We have concluded the initial discovery allowed by the court and filed our report with the court on May 27, 2005.  Contrary to AutoZone’s own statements to the court, we found through discovery, including depositions and other admissions of AutoZone, many instances of copying of programs containing our OpenServer code.  AutoZone has represented that it has now removed all of our 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 our code and proprietary information, we currently do not intend to move for a preliminary injunction. AutoZone does not admit that it violated our rights or

 

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caused us damage in that migration process, which are still points of dispute between the parties.  Given the stay issued by the Court in the case, we reserve the right to pursue infringement and damages in the future based on these issues and other issues stayed by the Court.

 

IPO Class Action Matter

 

We are 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 our 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 us and our directors.

 

We have notified our 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 our results of operations or financial position and will not exceed the $200,000 self-insured retention already paid or accrued by us.

 

Red Hat, Inc.

 

On August 4, 2003, Red Hat, Inc. filed a complaint against us. 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 our 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 that we have 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 our 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. We intend to vigorously defend this action. In the event the stay is lifted and Red Hat is allowed to pursue its claims, we will likely assert counterclaims against Red Hat.

 

Indian Distributor Matter

 

In April 2003, a former Indian distributor of our company filed a claim in India, requesting summary judgment for payment of $1,428,000, and an order that we trade in India only through the distributor and/or give a security deposit until the claim is paid.  The distributor claims that we are responsible to repurchase certain software products and to reimburse the distributor for certain other operating costs.  Management does not believe that we are responsible to reimburse the distributor for any operating costs and also believes that the return rights related to any remaining inventory have lapsed.  The distributor additionally requested that the Indian courts grant interim relief in the form of attachment of local assets.  These requests for interim relief have failed in the court, and discovery has commenced and hearings on the main claims have been held and are ongoing.  We intend to vigorously defend this action.

 

Pursuit and defense of the above-mentioned matters will continue to be costly, and management expects the costs for legal fees and related expenses will be substantial.

 

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The ultimate outcome or potential negative effect on our results of operations or financial position of each of the Red Hat, Inc., IPO Class Action, and the Indian Distributor matters is neither probable nor estimable.

 

We are 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 our results of operations, liquidity or financial position.

 

Item 4.  Submission of Matters to a Vote of Security Holders

 

There were no matters submitted to a vote of security holders during the three months ended October 31, 2005.

 

PART II

 

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Price of Our Common Stock

 

Our common stock initially traded on The Nasdaq National Market beginning in March 2000, but has been traded on The Nasdaq Capital Market (formerly known as the Nasdaq SmallCap Market) since February 2003.  In September 2002, we changed our trading symbol from “CALD” to “SCOX.”  The table below sets forth the range of high and low closing prices of our common stock as reported on the Nasdaq Capital Market, as applicable, for the last two years.

 

 

 

SCO Common Stock

 

 

 

High

 

Low

 

Year Ended October 31, 2005

 

 

 

 

 

Quarter ended January 31, 2005

 

$

4.99

 

$

2.85

 

Quarter ended April 30, 2005

 

4.60

 

3.42

 

Quarter ended July 31, 2005

 

4.22

 

3.50

 

Quarter ended October 31, 2005

 

4.93

 

3.75

 

 

 

 

 

 

 

Year Ended October 31, 2004

 

 

 

 

 

Quarter ended January 31, 2004

 

$

19.08

 

$

13.65

 

Quarter ended April 30, 2004

 

14.40

 

6.26

 

Quarter ended July 31, 2004

 

6.34

 

4.03

 

Quarter ended October 31, 2004

 

5.10

 

2.98

 

 

On January 20, 2006, the closing sales price for our common stock as reported by The Nasdaq Capital Market was $3.78.  As of January 20, 2006, there were 394 holders of common stock of record.

 

Dividend Policy

 

We have not historically declared or paid any cash dividends on shares of our common stock and plan to retain our future earnings, if any, to fund the development and growth of our business.

 

Issuer Purchases of Equity Securities

 

During the three months ended October 31, 2005, we did not purchase any of our equity securities.

 

20



 

Item 6.  Selected Financial Data

 

The following selected financial data set forth below should be read in conjunction with the consolidated financial statements and the related notes included elsewhere in this Form 10-K and in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in Part II, Item 7 of this Form 10-K.  The selected statement of operations data for the years ended October 31, 2005, 2004 and 2003 and the selected balance sheet data as of October 31, 2005 and 2004 are derived from, and are qualified by reference to, the audited consolidated financial statements and related notes in this Form 10-K.

 

The selected statement of operations data for the years ended October 31, 2002 and 2001 and the selected balance sheet data as of October 31, 2003, 2002 and 2001 are derived from audited consolidated financial statements not appearing in this Form 10-K.

 

 

 

Years Ended October 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

(In thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

 

 

Statement of Operations Data:

 

 

 

 

 

 

 

 

 

 

 

Total revenue

 

$

36,004

 

$

42,809

 

$

79,254

 

$

64,241

 

$

40,441

 

Gross margin

 

$

17,691

 

$

15,711

 

$

59,332

 

$

45,925

 

$

25,518

 

Income (loss) from operations

 

$

(11,899

)

$

(28,573

)

$

3,436

 

$

(24,176

)

$

(133,636

)

Net income available (loss applicable) to common stockholders

 

$

(10,726

)

$

(16,227

)

$

5,304

 

$

(24,877

)

$

(131,357

)

Basic net income (loss) per common share

 

$

(0.60

)

$

(1.07

)

$

0.43

 

$

(1.93

)

$

(10.92

)

Diluted net income (loss) per common share

 

$

(0.60

)

$

(1.07

)

$

0.34

 

$

(1.93

)

$

(10.92

)

Weighted average basic common shares

 

17,924

 

15,155

 

12,261

 

12,893

 

12,024

 

Weighted averaged diluted common shares

 

17,924

 

15,155

 

15,679

 

12,893

 

12,024

 

 

 

 

As of October 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

(In thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

4,272

 

$

12,693

 

$

64,428

 

$

6,589

 

$

20,541

 

Working capital (deficit)

 

8,669

 

15,413

 

37,168

 

(6,332

)

14,401

 

Total assets

 

28,948

 

55,400

 

94,952

 

37,406

 

74,859

 

Long-term liabilities

 

338

 

343

 

508

 

1,625

 

5,925

 

Redeemable preferred stock

 

 

 

29,671

 

 

 

Common stock subject to rescission

 

1,018

 

528

 

 

 

 

Total stockholders’ equity

 

11,337

 

21,702

 

19,516

 

8,177

 

34,604

 

 

Item 7.  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 Form 10-K 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 discussed in the subsection entitled “Forward-Looking Statements and Factors That May Affect Future Results and Financial Condition” and the subsection entitled “Risk Factors” under Part I, Item 1A of this Form 10-K.  The following discussion should be read in conjunction with our consolidated financial statements and notes thereto included in Part II, Item 8 of this Form 10-K.  All information

 

21



 

presented herein is based on our fiscal year ended October 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 (as previously defined, “Caldera Systems”), on August 21, 1998, and reincorporated as a Delaware corporation on March 6, 2000.  In March 2000, we completed an initial public offering of our common stock.  On May 7, 2001, we formed a new holding company in Delaware under the name of Caldera International, Inc. (as previously defined, “Caldera International”) to acquire substantially all of the assets and operations of the server and professional services groups of The Santa Cruz Operation.  In connection with this acquisition, Caldera Systems became a wholly owned subsidiary of Caldera International.  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.  On May 16, 2003, our stockholders approved our corporate name change to The SCO Group, Inc.

 

Recent Developments.  We discovered in 2005 that we had offered and sold shares of our common stock under our 2000 Employee Stock Purchase Plan, or ESPP, 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, those current and former employees had a right to rescind their purchases of shares under the ESPP or recover damages if they no longer owned the shares, subject to applicable statutes of limitations.

 

In December 2005, we offered to rescind a total of 337,289 shares of common stock issued under our ESPP to current and former employees while they resided in California, Connecticut, Illinois, New Jersey, Utah, Texas or Washington.  These shares represented all of the ESPP shares we issued to residents of these states for which a purchaser could claim a rescission right.  The rescission offer was intended to address our rescission liability relating to our federal and state securities laws compliance issues by allowing the holders of the shares covered by the rescission offer to rescind the underlying securities transactions and sell those securities back to us or recover damages, as the case may be.

 

Our rescission offer concluded on January 20, 2006.  As of that date, 14 offerees had accepted our offer to rescind the purchase of approximately 7,300 shares issued under our ESPP.  We plan to make aggregate payments to such offerees of approximately $41,500, which includes approximately $9,700 in applicable statutory interest and damages.  As a result of the rescission offer, we believe we have extinguished our state rescission liability and mitigated our federal rescission liability to anyone to whom the rescission offer was made for noncompliance with the registration or qualification requirements of federal and state securities laws as they relate to the shares issued under our ESPP.

 

The rescission offer did not address stock options that may have been issued without registration or qualification requirements under the securities laws of California, Georgia and possibly other states.  We may still face rescission liability to plan participants holding unexercised stock options in these states.

 

Business Focus

 

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.

 

22



 

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 years 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 and footnote shows the operating results of the UNIX business for the years ended October 31, 2005, 2004 and 2003 (in thousands):

 

 

 

2005

 

2004

 

2003

 

 

 

 

 

 

 

 

 

Revenue

 

$

35,838

 

$

41,980

 

$

53,408

 

Cost of revenue

 

5,466

 

7,355

 

10,422

 

Gross margin

 

30,372

 

34,625

 

42,986

 

Sales and marketing

 

11,666

 

15,806

 

24,392

 

Research and development

 

7,940

 

10,126

 

11,012

 

General and administrative

 

6,604

 

7,385

 

6,230

 

Other (1)

 

2,394

 

9,008

 

5,306

 

Total operating expenses

 

28,604

 

42,325

 

46,940

 

Income (loss) from operations

 

$

1,768

 

$

(7,700

)

$

(3,954

)

 


(1)                      For the year ended October 31, 2005, other costs included $2,372 of amortization of intangibles and $22 of stock-based compensation.  For the year ended October 31, 2004, other costs included $3,168 of severance and exit costs, $2,566 of amortization of intangibles, $2,355 of losses on disposition and impairment of long-lived assets, and $919 of stock-based compensation.  For the year ended October 31, 2003, other costs included $3,190 of amortization of intangibles, $1,204 of stock-based compensation, $498 of severance and exit costs, $250 of write-offs of investments, and $164 of losses on disposition and impairment of long-lived assets.

 

Revenue from our UNIX business decreased by $6,142,000, or 15%, for the year ended October 31, 2005 compared to the year ended October 31, 2004 and decreased by $11,428,000, or 21%, for the year ended October 31, 2004 compared to the year ended October 31, 2003.  The revenue from our UNIX business has been declining over the last several years primarily as a result of continued competition from alternative operating systems, particularly Linux.  We believe that the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX business revenue because users of Linux generally do not pay for the operating system itself, but for services and maintenance.

 

In an effort to attain profitability in our UNIX business, we have decreased our costs in each of the last three years.  Operating costs for our UNIX business decreased from $46,940,000 for the year ended October 31, 2003, to $42,325,000 for the year ended October 31, 2004, and then further decreased to $28,604,000 for the year ended October 31, 2005.  These cost reductions have primarily been attributable to reduced headcount and consolidation of certain facilities.

 

In our UNIX business, we have reduced the number of full-time equivalent employees from 295 as of October 31, 2003, to 193 as of October 31, 2004, and to 163 as of October 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 have planned that our UNIX business will continue to generate positive cash flow during the year ending October 31, 2006.

 

The decline in our UNIX business revenue may be accelerated if industry partners withdraw their support as a result of our SCO Litigation.  The decline in our UNIX business and the SCO Litigation may cause industry partners, developers and hardware and software vendors to choose not to support or

 

23



 

certify to our UNIX operating system products.  This would lead to an accelerated decline in revenue from our UNIX business.

 

SCOsource Business.  During the year ended October 31, 2003, we became aware that our UNIX code and derivative works had been inappropriately included by others in the Linux operating system.  We believe the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX business because users of Linux generally do not pay for the operating system itself, but pay for services and maintenance.  The Linux operating system competes directly with our OpenServer and UnixWare products and has taken significant market share from these products.

 

In an effort to protect our UNIX intellectual property, we initiated our SCOsource business.  Our SCOsource revenue for the years ended October 31, 2004 and 2005 was significantly lower than revenue generated during the year ended October 31, 2003 and we believe and allege our revenue and related revenue opportunities have been adversely impacted by Novell’s claim of UNIX copyright ownership, which may have caused potential customers to delay or forego licensing until an outcome in this legal matter has been reached.

 

The following table shows the results of operations for the SCOsource business (in thousands):

 

 

 

2005

 

2004

 

2003

 

 

 

 

 

 

 

 

 

Revenue

 

$

166

 

$

829

 

$

25,846

 

Cost of revenue

 

12,847

 

19,743

 

9,500

 

Gross margin (deficit)

 

(12,681

)

(18,914

)

16,346

 

Sales and marketing

 

154

 

1,232

 

 

Research and development

 

389

 

486

 

 

General and administrative

 

443

 

241

 

 

Compensation to law firms

 

 

 

8,956

 

Total operating expenses

 

986

 

1,959

 

8,956

 

Income (loss) from operations

 

$

(13,667

)

$

(20,873

)

$

7,390

 

 

Revenue from our SCOsource business decreased from $25,846,000 for the year ended October 31, 2003, to $829,000 for the year ended October 31, 2004, and to $166,000 for the year ended October 31, 2005.  During the year ended October 31, 2003, SCOsource revenue was primarily attributable to two large vendor licenses.  We did not close similar transactions during the years ended October 31, 2005 and 2004.  Revenue for the years ended October 31, 2005 and 2004 was primarily attributable to sales of our SCOsource IP agreements.

 

Cost of revenue increased from $9,500,000 for the year ended October 31, 2003 to $19,743,000 for the year ended October 31, 2004, which was primarily attributable to increased legal fees incurred in connection with our SCO Litigation.  Cost of revenue decreased to $12,847,000 for the year ended October 31, 2005 and this decrease was 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 costs.  The decrease in operating expenses was primarily attributable to decreased personnel and related costs.

 

Operating expenses for sales and marketing, research and development and general and administrative decreased from $1,959,000 during the year ended October 31, 2004 to $986,000 during the year ended October 31, 2005.  The decrease in operating expenses was primarily attributable to decreased personnel and related costs.  The other expense for the year ended October 31, 2003 of $8,956,000 was attributable to a contingency fee payable to the Law Firms incurred in connection with the October 2003 issuance of our now retired Series A Convertible Preferred Stock.  This fee was not for attorney’s fees for legal services, which fees have been recorded as cost of SCOsource licensing revenue and was paid in November 2004.

 

24



 

Because of the uncertainties related to our SCOsource business, we are unable to estimate the amount and timing of future SCOsource licensing revenue.  We are unlikely to generate significant revenue from our SCOsource business unless and until we prevail in our SCO Litigation.  Additionally, the success of the SCOsource business may depend on the strength of our intellectual property rights and claims regarding UNIX, including our claims against Novell and the strength of our claim that unauthorized UNIX source code and derivative works are contained in Linux.

 

Critical Accounting Estimates

 

The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and our discussion and analysis of our financial condition and results of operations requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes.  Note 2 of the notes to consolidated financial statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in preparation of our consolidated financial statements.  We base our estimates on historical experience, current trends, future projections, and on various other assumptions we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities.  Actual results may differ from these estimates.  We believe the following to be our critical accounting estimates because they are both important to the portrayal of our financial condition and results and they require us to make judgments and estimates about matters that are inherently uncertain.

 

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

 

                            Allowances 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 reasonably assured 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

 

 

25



 

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, if any, and other future events, the effects of which cannot be determined.  We have provided a valuation allowance of $69,239,000 against our entire net deferred tax asset as of October 31, 2005.  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 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 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.

 

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

 

We performed an impairment analysis as of October 31, 2005 and determined that the fair value of our remaining long-lived assets was in excess of the current carrying values and that no impairment had occurred.  Judgment from management is required to determine if a triggering event has occurred and in forecasting future operating results.

 

Write-downs of intangible assets may be necessary if the future fair value of these assets is less than carrying value.  If the operating trends for our UNIX or SCOsource businesses continue to 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,

 

26



 

which is determined based on our historical experience and a specific review of customer balances, was $144,000 as of October 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.

 

Results of Operations

 

The following table presents our results of operations for the years ended October 31, 2005, 2004 and 2003 (in thousands):

 

 

 

Years Ended October 31,

 

Statement of Operations Data:

 

2005

 

2004

 

2003

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

Products

 

$

30,190

 

$

35,352

 

$

45,028

 

SCOsource licensing

 

166

 

829

 

25,846

 

Services

 

5,648

 

6,628

 

8,380

 

Total revenue

 

36,004

 

42,809

 

79,254

 

Cost of revenue:

 

 

 

 

 

 

 

Products

 

2,544

 

3,221

 

4,068

 

SCOsource licensing

 

12,847

 

19,743

 

9,500

 

Services

 

2,922

 

4,134

 

6,354

 

Total cost of revenue

 

18,313

 

27,098

 

19,922

 

Gross margin

 

17,691

 

15,711

 

59,332

 

Operating expenses:

 

 

 

 

 

 

 

Sales and marketing

 

11,820

 

17,038

 

24,392

 

Research and development

 

8,329

 

10,612

 

11,012

 

General and administrative

 

7,047

 

7,626

 

6,230

 

Severance and exit costs

 

 

3,168

 

498

 

Amortization of intangibles

 

2,372

 

2,566

 

3,190

 

Loss on disposition and impairment of long-lived assets

 

 

2,355

 

164

 

Write-off of investments

 

 

 

250

 

Stock-based compensation

 

22

 

919

 

1,204

 

Compensation to law firms

 

 

 

8,956

 

Total operating expenses

 

29,590

 

44,284

 

55,896

 

Income (loss) from operations

 

(11,899

)

(28,573

)

3,436

 

Equity in income (losses) of affiliates

 

47

 

111

 

(62

)

Other income, net

 

1,399

 

6,507

 

2,827

 

Provision for income taxes

 

(273

)

(1,395

)

(774

)

Net income (loss)

 

(10,726

)

(23,350

)

5,427

 

Contributions from (dividends on) redeemable convertible preferred stock

 

 

7,123

 

(123

)

Net income available (loss applicable) to common stockholders

 

$

(10,726

)

$

(16,227

)

$

5,304

 

 

Years Ended October 31, 2005, 2004 and 2003

 

Revenue

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

36,004,000

 

(16

)%

$

42,809,000

 

(46

)%

$

79,254,000

 

 

Revenue for the year ended October 31, 2005 decreased by $6,805,000, or 16%, from the year ended October 31, 2004.  This decrease was primarily attributable to a decrease in UNIX products and

 

27



 

services revenue as a result of continued competition from other operating systems, primarily Linux.  Revenue for the year ended October 31, 2004 decreased by $36,445,000, or 46%, from the year ended October 31, 2003.  This decrease was primarily attributable to significantly lower SCOsource licensing revenue in the year ended October 31, 2004 compared to the year ended October 31, 2003 as well as a continued decline in our UNIX business.

 

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

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

UNIX revenue

 

$

35,838,000

 

(15

)%

$

41,980,000

 

(21

)%

$

53,408,000

 

Percent of total revenue

 

100

%

 

 

98

%

 

 

67

%

SCOsource revenue

 

166,000

 

(80

)%

829,000

 

(97

)%

25,846,000

 

Percent of total revenue

 

0

%

 

 

2

%

 

 

33

%

 

The decrease in revenue in the UNIX business of $6,142,000 for the year ended October 31, 2005 compared to the year ended October 31, 2004 and the decrease in revenue of $11,428,000 for the year ended October 31, 2004 compared to the year ended October 31, 2003 was primarily attributable to continued competition from other operating systems, particularly Linux.  We believe that the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX revenue because users of Linux generally do not pay for the operating system itself, but pay for services and maintenance.  We anticipate that for the year ending October 31, 2006 our total UNIX revenue will decline from UNIX revenue generated in the year ended October 31, 2005 as a result of this continued competition.

 

SCOsource revenue decreased by $663,000 for the year ended October 31, 2005 compared to the year ended October 31, 2004 and this decrease was primarily attributable to reduced sales of IP agreements.  The decrease in SCOsource licensing revenue of $25,017,000 from the year ended October 31, 2003 to the year ended October 31, 2004 was primarily attributable to minimal vendor licensing revenue in the year ended October 31, 2004 compared to significant vendor licensing revenue generated in the year ended October 31, 2003 as a result of two large vendor licenses.

 

Sales of our UNIX products and services during the years ended October 31, 2005, 2004 and 2003 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 SCO Litigation.

 

Products Revenue

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Products revenue

 

$

30,190,000

 

(15

)%

$

35,352,000

 

(21

)%

$

45,028,000

 

Percent of total revenue

 

84

%

 

 

83

%

 

 

57

%

 

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 end-user 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.

 

28



 

The decrease in products revenue of $5,162,000 from the year ended October 31, 2004 to the year ended October 31, 2005 and the decrease of $9,676,000 from the year ended October 31, 2003 to the year ended October 31, 2004 was primarily attributable to decreased sales of OpenServer and UnixWare products primarily resulting from continued competition in the operating system market, particularly Linux.  We believe that this competition from Linux will continue for the year ending October 31, 2006 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:

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

OpenServer revenue

 

$

16,720,000

 

(9

)%

$

18,467,000

 

(17

)%

$

22,162,000

 

Percent of products revenue

 

55

%

 

 

52

%

 

 

49

%

UnixWare revenue

 

8,979,000

 

(19

)%

11,125,000

 

(21

)%

14,083,000

 

Percent of products revenue

 

30

%

 

 

32

%

 

 

31

%

Other products revenue

 

4,491,000

 

(22

)%

5,760,000

 

(34

)%

8,783,000

 

Percent of products revenue

 

15

%

 

 

16

%

 

 

20

%

 

The decreases in revenue for OpenServer, UnixWare and other products are all primarily the result of continued competition, particularly from Linux operating system providers.

 

SCOsource Licensing Revenue

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

SCOsource licensing revenue

 

$

166,000

 

(80

)%

$

829,000

 

(97

)%

$

25,846,000

 

Percent of total revenue

 

0

%

 

 

2

%

 

 

33

%

 

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 $166,000 for the year ended October 31, 2005 and $829,000 for the year ended October 31, 2004, down significantly from revenue of $25,846,000 generated in the year ended October 31, 2003.  The SCOsource revenue for the years ended October 31, 2005 and 2004 was primarily attributable to sales of SCOsource IP agreements and the SCOsource licensing revenue in the year ended October 31, 2003 was primarily attributable to fees associated with two significant vendor licenses.  We believe and allege that our decrease in SCOsource revenue for the years ended October 31, 2005 and 2004 was in part attributable to Novell’s claim of UNIX copyright ownership, which may have caused potential customers to delay or forego licensing until an outcome in this legal matter has been reached.

 

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

 

Services Revenue

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Services revenue

 

$

5,648,000

 

(15

)%

$

6,628,000

 

(21

)%

$

8,380,000

 

Percent of total revenue

 

16

%

 

 

15

%

 

 

11

%

 

Services revenue consists primarily of annual and incident technical support fees, engineering services fees, professional services and consulting fees.  These fees are typically charged and invoiced separately from UNIX products sales.  The decrease in services revenue of $980,000, or 15%, from the year ended October 31, 2004 to the year ended October 31, 2005 and the decrease of $1,752,000, or 21%, from

 

29



 

the year ended October 31, 2003 to the year ended October 31, 2004 was primarily attributable to a decrease in products revenue and decreased 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.

 

Cost of Products Revenue

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of products revenue

 

$

2,544,000

 

(21

)%

$

3,221,000

 

(21

)%

$

4,068,000

 

Percentage of products revenue

 

8

%

 

 

9

%

 

 

9

%

 

Cost of products revenue consists of manufacturing costs, royalties to third-party vendors, technology costs and overhead costs.  Cost of products revenue decreased by $677,000, or 21%, from the year ended October 31, 2004 to the year ended October 31, 2005 and decreased $847,000, or 21%, from the year ended October 31, 2003 to the year ended October 31, 2004.  This decrease in cost of products revenue was primarily attributable to lower products revenue, as margins did not vary significantly.

 

For the year ending October 31, 2006, we expect the dollar amount of our cost of products revenue to be less than the year ended October 31, 2005 and, as a percentage of products revenue, to be consistent with the percentage achieved during the year ended October 31, 2005.

 

Cost of SCOsource Licensing Revenue

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of SCOsource licensing revenue

 

$

12,847,000

 

(35

)%

$

19,743,000

 

108

%

$

9,500,000

 

 

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

 

Cost of SCOsource licensing revenue decreased by $6,896,000, or 35%, from the year ended October 31, 2004 to the year ended October 31, 2005 and was primarily attributable to decreased legal costs incurred in connection with the SCO Litigation as a result of our Engagement Agreement with the Law Firms representing us.  Cost of SCOsource licensing revenue increased by $10,243,000, or 108%, from the year ended October 31, 2003 to the year ended October 31, 2004 and was primarily attributable to increased legal costs incurred in connection with our SCO Litigation.

 

We anticipate that the dollar amount of our cost of SCOsource licensing revenue for the year ending October 31, 2006 will be lower than for the year ended October 31, 2005 as we make our final $2,000,000 payment that is due to the Law Firms and continue to make payments for expert, consulting and other fees.  However, future legal fees may include contingency payments made to the Law Firms as a result of a settlement, judgment, or a sale of our company, which could cause cost of SCOsource licensing revenue for the year ending October 31, 2006 to be higher than the year ended October 31, 2005.

 

Cost of Services Revenue

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of services revenue

 

$

2,922,000

 

(29

)%

$

4,134,000

 

(35

)%

$

6,354,000

 

Percentage of services revenue

 

52

%

 

 

62

%

 

 

76

%

 

30



 

Cost of services revenue includes the salaries and related personnel costs of employees delivering services revenue as well as third-party service agreements.  Cost of services revenue decreased by $1,212,000, or 29%, from the year ended October 31, 2004 to the year ended October 31, 2005 and decreased by $2,220,000, or 35%, from the year ended October 31, 2003 to the year ended October 31, 2004 and was primarily attributable to reduced employee and employee-related costs.

 

For the year ending October 31, 2006, we expect the dollar amount of our cost of services revenue to be less than that incurred for the year ended October 31, 2005 and that cost of services revenue as a percentage of services revenue will be consistent to that generated for the year ended October 31, 2005.

 

Sales and Marketing

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing expense

 

$

11,820,000

 

(31

)%

$

17,038,000

 

(30

)%

$

24,392,000

 

Percentage of total revenue

 

33

%

 

 

40

%

 

 

31

%

 

Sales and marketing expenses consist of the salaries, commissions and other personnel costs of employees involved in the revenue generation process, as well as advertising and corporate allocations.  The decrease in sales and marketing expense of $5,218,000, or 31%, from the year ended October 31, 2004 to the year ended October 31, 2005, and the decrease of $7,354,000, or 30%, from the year ended October 31, 2003 to the year ended October 31, 2004 was primarily attributable to reductions in sales and marketing employees, reduced travel expenses, less commissions and lower advertising costs.  The decrease in sales and marketing expense as a percentage of revenue from the year ended October 31, 2004 to the year ended October 31, 2005 was the result of costs decreasing at a greater pace than our revenue decline and the increase from the year ended October 31, 2003 to the year ended October 31, 2004 was a result of lower revenue for the year ended October 31, 2004.  Our sales and marketing full-time equivalent employees decreased from 114 as of October 31, 2003, to 62 as of October 31, 2004 to 55 as of October 31, 2005.

 

For the year ending October 31, 2006, we anticipate that the dollar amount of sales and marketing expense will decrease from the year ended October 31, 2005.

 

Research and Development

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development expense

 

$

8,329,000

 

(22

)%

$

10,612,000

 

(4

)%

$

11,012,000

 

Percentage of total revenue

 

23

%

 

 

25

%

 

 

14

%

 

Research and development expense consists of the salaries and benefits of software engineers, consulting expenses and corporate allocations.  Research and development expense decreased by $2,283,000, or 22%,  from the year ended October 31, 2004 to the year ended October 31, 2005 and decreased by $400,000, or 4%, from the year ended October 31, 2003 to the year ended October 31, 2004.  During the years ended October 31, 2005 and 2004, our engineering efforts were focused on the release of UnixWare 7.1.4 and on the release of OpenServer 6; both significant releases of our two primary operating system products.  These development efforts required us to maintain our research and development infrastructure, which limited our ability to cut costs in this area as significantly as we have done in other areas.  Research and development expense as a percentage of revenue declined in the year ended October 31, 2005 as compared to the year ended October 31, 2004 as a result of costs decreasing at a greater pace than our revenue declined.  Research and development expense as a percentage of revenue increased in the year ended October 31, 2004 as compared to the year ended October 31, 2003 as a result

 

31



 

of lower revenue in fiscal year 2004.  Our research and development full-time equivalent employees decreased from 75 as of October 31, 2003, to 64 as of October 31, 2004 to 49 as of October 31, 2005.

 

For the year ending October 31, 2006, we anticipate that the dollar amount of research and development expense will decrease from the year ended October 31, 2005.

 

General and Administrative

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative expense

 

$

7,047,000

 

(8

)%

$

7,626,000

 

22

%

$

6,230,000

 

Percentage of total revenue

 

20

%

 

 

18

%

 

 

8

%

 

General and administrative expense consists of the salaries and benefits of finance, human resources, and executive management and expenses for professional services such as legal and accounting services and corporate allocations.  General and administrative expense decreased by $579,000, or 8%, from the year ended October 31, 2004 to the year ended October 31, 2005.  This decrease was primarily attributable to lower personnel and related costs offset by increased legal and accounting costs related to the restatement of our quarterly financial statements and the preparation of our recently completed rescission offer.  General and administrative expense increased by $1,396,000, or 22%, from the year ended October 31, 2003 to the year ended October 31, 2004.  The increase in general and administrative expense was primarily attributable to increased legal costs as a result of corporate and regulatory legal matters not classified as cost of SCOsource licensing revenue and increased fees from other professional service providers.  General and administrative expense as a percent of total revenue increased during the years ended October 31, 2005 and 2004 as a result of increased costs and lower revenue.  Our general and administrative full-time equivalent employees decreased from 55 as of October 31, 2003, to 36 as of October 31, 2004, to 28 as of October 31, 2005.

 

For the year ending October 31, 2006, we anticipate that the dollar amount of general and administrative expense will decrease from the year ended October 31, 2005.

 

Severance and Exit Costs

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Severance and exit costs

 

$

 

n/a

 

$

3,168,000

 

536

%

$

498,000

 

Percentage of total revenue

 

0

%

 

 

7

%

 

 

1

%

 

During the year ended October 31, 2005, we did not record any charges for severance and exit costs.  During the years ended October 31, 2004 and 2003, we recorded severance and exit costs totaling $3,168,000 and $498,000, respectively.  The severance and exit costs for the years ended October 31, 2004 and 2003 were comprised of termination payments made to employees in connection with reductions in headcount, closure of certain facilities and adjustments to previously recorded amounts as actual payments made were less than recorded accruals.

 

32



 

The detail of the activity in the accrual for severance and exit costs for the years ended October 31, 2005, 2004 and 2003, are as follows:

 

Year Ended October 31,
2005

 

Balance at
November 1, 2004

 

Additions

 

Adjustments

 

Utilization

 

Balance at October 31, 2005

 

 

 

 

 

 

 

 

 

 

 

 

 

Ongoing severance and other

 

$

401,000

 

$

 

$

 

$

(401,000

)

$

 

 

Year Ended October 31,
2004

 

Balance at
November 1, 2003

 

Additions

 

Adjustments

 

Utilization

 

Balance at
October 31, 2004

 

 

 

 

 

 

 

 

 

 

 

 

 

One-time severance

 

$

 

$

309,000

 

$

 

$

(309,000

)

$

 

Ongoing severance and other

 

 

2,071,000

 

 

(1,670,000

)

401,000

 

Facilities

 

348,000

 

788,000

 

 

(1,136,000

)

 

Total

 

$

348,000

 

$

3,168,000

 

$

 

$

(3,115,000

)

$

401,000

 

 

Year Ended October 31,
2003

 

Balance at
November 1, 2002

 

Additions

 

Adjustments

 

Utilization

 

Balance at
October 31, 2003

 

 

 

 

 

 

 

 

 

 

 

 

 

One-time severance

 

$

 

$

198,000

 

$

 

$

(198,000

)

$

 

Ongoing severance and other

 

560,000

 

1,388,000

 

(273,000

)*

(1,675,000

)

 

Facilities

 

2,117,000

 

 

(815,000

)*

(954,000

)

348,000

 

Total

 

$

2,677,000

 

$

1,586,000

 

$

(1,088,000

)

$

(2,827,000

)

$

348,000

 

 


* The facilities adjustment of $815,000 was the result of successfully negotiating out of lease commitments in connection with our winding down of SCO Group, Ltd. in the United Kingdom and the ongoing severance and other adjustment of $273,000 was related to the true-up of previously recorded accruals.

 

Amortization of Intangibles

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortization of intangibles

 

$

2,372,000

 

(8

)%

$

2,566,000

 

(20

)%

$

3,190,000

 

Percentage of total revenue

 

7

%

 

 

6

%

 

 

4

%

 

During the years ended October 31, 2005, 2004 and 2003, we recorded $2,372,000, $2,566,000 and $3,190,000, respectively, for the amortization of intangible assets with finite lives.  The decrease of $194,000, or 8%, from the year ended October 31, 2005 compared to the year ended October 31, 2004 was primarily attributable to reduced amortization expense recorded on certain assets acquired from Vultus in June 2003 that were written off during the year ended October 31, 2004.  The decrease of $624,000, or 20%, from the year ended October 31, 2003 to the year ended October 31, 2004 was primarily attributable to reduced amortization expense recorded on certain assets acquired from Vultus that were written off during the year ended October 31, 2004 and therefore were not amortized for the last half of the year ending October 31, 2004.

 

Loss on Disposition and Impairment of Long-lived Assets

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss on disposition and write-down of long-lived assets

 

$

 

(100

)%

$

2,355,000

 

1,336

%

$

164,000

 

Percentage of total revenue

 

0

%

 

 

6

%

 

 

0

%

 

33



 

During the year ended October 31, 2005, we did not have any losses on the disposition and impairment of long-lived assets.  During the years ended October 31, 2004 and 2003, we recorded a write down of long-lived assets of $2,355,000 and $164,000, respectively.  The loss on disposition and write-down of long-lived assets recorded during the year ended October 31, 2004 primarily related to goodwill and intangible assets acquired in connection with our acquisition of Vultus in June 2003.  We concluded that an impairment triggering event occurred during the year ended October 31, 2004 as we had a reduction in force that impacted our ability to move the Vultus initiative forward on a stand-alone basis and because an anticipated partnership that would have solidified the Vultus revenue and cash flow opportunities did not materialize.  Consequently, we concluded that no significant future cash flows related to our Vultus assets will be realized.  The loss on disposition and write-down of long-lived assets recorded during the year ended October 31, 2003 was primarily attributable to assets written off in connection with restructurings that occurred during that year.

 

Write-offs of Investments

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Write-offs of investments

 

$

 

n/a

 

$

 

n/a

 

$

250,000

 

Percentage of total revenue

 

0

%

 

 

0

%

 

 

0

%

 

Management routinely assesses our investments for impairments and adjusts the carrying amounts to estimated realizable values when impairment has occurred.  During the years ended October 31, 2005 and 2004, we did not have any write-offs of investments.  During the year ended October 31, 2003, in connection with the restructuring of our investment in and relationship with Vista.com, Inc. (“Vista”), we recorded a write-off of our Vista investment and incurred a charge of $250,000.  We had been accounting for our investment in Vista under the equity method of accounting.

 

Stock-based Compensation

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation

 

$

22,000

 

(98

)%

$

919,000

 

(24

)%

$

1,204,000

 

Percentage of total revenue

 

0

%

 

 

2

%

 

 

2

%

 

Stock-based compensation consisted of the following components for the years ended October 31, 2005, 2004 and 2003:

 

 

 

2005

 

2004

 

2003

 

 

 

 

 

 

 

 

 

Amortization of stock-based compensation

 

$

22,000

 

$

325,000

 

$

866,000

 

Options, warrants and shares for services

 

 

502,000

 

296,000

 

Modifications to options

 

 

92,000

 

42,000

 

Total

 

$

22,000

 

$

919,000

 

$

1,204,000

 

 

As of October 31, 2005, there was a $0 balance in deferred compensation.  In accordance with SFAS No. 123R, for the year ending October 31, 2006, all stock-based compensation expense will be reclassified and presented in the various applicable captions in the statement of operations, as opposed to the current single line item presentation.

 

34



 

Compensation to Law Firms

 

 

 

2005

 

Change

 

2004

 

Change

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

Compensation to law firms

 

$

 

n/a

 

$

 

n/a

 

$

8,956,000

 

Percentage of total revenue

 

0

%

 

 

0

%

 

 

11

%

 

During the year ended October 31, 2003, we incurred contingency fees of $8,956,000, or 11% of revenue, related to our arrangement with the Law Firms representing us in the SCO Litigation in connection with the issuance of shares of our now retired Series A Convertible Preferred Stock.  All payments to the Law Firms for other legal fees incurred in connection with the SCO Litigation have been classified as cost of SCOsource licensing revenue.

 

Equity in Income (Losses) of Affiliate

 

We account for our ownership interests in companies in which we own at least 20 percent and less than 50 percent using the equity method of accounting.  Under the equity method, we record our portion of the entities’ net income or net loss in our consolidated statements of operations.  As of October 31, 2005, the carrying value of our investments of $606,000 was related to our 30 percent ownership in a Chinese company.

 

During the years ended October 31, 2005, 2004 and 2003, we recorded $47,000, $111,000 and ($62,000), respectively, that related to net income (losses) in these entities.  The income reported during the years ended October 31, 2005 and 2004 was attributable to our portion of the net income generated by the above-mentioned Chinese company.  The loss reported during the year ended October 31, 2003 was primarily attributable to losses generated from Vista.

 

Other Income, net

 

Other income (expense) consisted of the following components for the years ended October 31, 2005, 2004 and 2003:

 

 

 

2005

 

2004

 

2003

 

 

 

 

 

 

 

 

 

Interest income

 

$

377,000

 

$

905,000

 

$

188,000

 

Interest expense

 

 

 

(3,000

)

Change in fair value of derivative

 

 

5,924,000

 

2,845,000

 

Other income (expense), net

 

1,022,000

 

(322,000

)

(203,000

)

Total other income, net

 

$

1,399,000

 

$

6,507,000

 

$

2,827,000

 

 

Interest income decreased by $528,000 from the year ended October 31, 2004 to the year ended October 31, 2005 and increased by $717,000 from the year ended October 31, 2003 to the year ended October 31, 2004.  The changes in interest income are the result of changes in our cash and available-for-sale securities balances.

 

The income recorded on the change in fair value of derivative for the years ended October 31, 2004 and 2003 related to the decrease in fair value of this instrument and marking it to market at each balance sheet date.  The derivative financial instrument was eliminated during the three months ended April 30, 2004.

 

The increase in other income, net, from the year ended October 31, 2004 to the year ended October 31, 2005 was primarily attributable to two items: 1) the collection of a note receivable from Vintela, Inc. (“Vintela”) as described in more detail in Note 12 to our financial statements, which note receivable was originally received in April 2003, but because we received the note receivable in exchange

 

35



 

for the transfer of certain software to a related party and there was substantial doubt concerning the ability of Vintela to repay the note, no gain was recognized until the three months ended January 31, 2005 when we received payment; and 2) the sale of shares we held in Troll Tech AS (“Troll Tech”) as described in more detail in Note 5 to our financial statements.  The Troll Tech shares had been written off in the year ended October 31, 2001, but because they were sold during the three months ended April 30, 2005, we recorded income for the proceeds received.

 

Provision for Income Taxes

 

The provision for income taxes for the years ended October 31, 2005, 2004 and 2003 was $273,000, $1,395,000 and $774,000, respectively.  The decrease in the provision for income taxes of $1,122,000 from the year ended October 31, 2004 to the year ended October 31, 2005 and the increase of $621,000 from the year ended October 31, 2003 to the year ended October 31, 2004 was primarily attributable to an accrual for withholding taxes of approximately $710,000 made in the year ended October 31, 2004 in connection with our operations in India.  Other than the accrual previously mentioned, our provision for income taxes is primarily related to earnings in foreign subsidiaries as well as from withholding taxes on revenue generated in certain foreign locations.

 

As of October 31, 2005, we had net operating loss carry-forwards for U.S. federal and state income tax reporting purposes of approximately $144,980,000 that expire at various dates between 2019 and 2025.  We had net deferred tax assets, including net operating loss carry-forwards and other temporary differences between book and tax deductions, totaling approximately $69,292,000 as of October 31, 2005.  We also had net deferred tax liabilities of approximately $53,000 related to taxes on foreign earnings.  A valuation allowance in the amount of $69,239,000, the difference between our deferred tax assets and liabilities, has been recorded as of October 31, 2005 as a result of uncertainties regarding the ultimate realizability of the net deferred tax assets.

 

Contributions From (Dividends On) Redeemable Convertible Preferred Stock

 

In October 2003, we issued 50,000 shares of our Series A Convertible Preferred Stock for $1,000 per share.   In connection with completing the February 5, 2004 exchange of shares of Series A-1 Convertible Preferred Stock for outstanding Series A shares, we removed the carrying value of the Series A shares and related derivative and recorded the fair value of the Series A-1 shares issued in the exchange transaction.  The difference between these two amounts was $6,305,000 and was recorded as a non-cash dividend during the year ended October 31, 2004.

 

With the completion of the repurchase transaction with BayStar Capital II, L.P. (“BayStar”) during the year ended October 31, 2004, as a result of which no Series A-1 shares remain outstanding, we will not be required to continue to accrue or pay any dividends on the Series A-1 shares.  As a result of completing the repurchase transaction with BayStar, we recorded a capital contribution classified as a preferred stock dividend in the amount of $15,475,000, which represented the difference in the carrying value of the Series A-1 shares and accrued dividends less the fair value of the 2,105,263 shares of common stock and the $13,000,000 in cash.  No dividends were paid on the Series A or Series A-1 shares.

 

The following table details the components of the dividends for the years ended October 31, 2005, 2004 and 2003:

 

 

 

2005

 

2004

 

2003

 

 

 

 

 

 

 

 

 

Accrual of dividends on preferred stock

 

$

 

$

(2,047,000

)

$

(123,000

)

Exchange of Series A shares for Series A-1 shares

 

 

(6,305,000

)

 

Repurchase of Series A-1 shares from BayStar

 

 

15,475,000

 

 

Total

 

$

 

$

7,123,000

 

$

(123,000

)

 

36



 

Quarterly Results of Operations

 

The following table sets forth certain unaudited quarterly statement of operations data for the last eight quarters.  This information has been derived from our unaudited consolidated financial statements, which, in management’s opinion, have been prepared on the same basis as the audited financial statements and include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the information for the quarters presented.  This information should be read in conjunction with the audited consolidated financial statements and related notes included elsewhere in this Form 10-K.  The operating results for any quarter are not necessarily indicative of the operating results for any future period.

 

 

 

Quarter Ended

 

 

 

January 31,
2005

 

April 30,
2005

 

July 31,
2005

 

October 31,
2005

 

 

 

(unaudited)

 

 

 

(In thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

8,865

 

$

9,258

 

$

9,353

 

$

8,528

 

Gross margin

 

3,979

 

5,060

 

4,873

 

3,779

 

Loss from operations

 

(3,409

)

(2,656

)

(2,242

)

(3,592

)

Net loss applicable to common stockholders

 

(2,961

)

(1,962

)

(2,372

)

(3,431

)

Net loss per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.17

)

$

(0.11

)

$

(0.13

)

$

(0.19

)

Diluted

 

$

(0.17

)

$

(0.11

)

$

(0.13

)

$

(0.19

)

Weighted average basic common shares

 

17,751

 

17,913

 

17,993

 

18,038

 

Weighted average diluted common shares

 

17,751

 

17,913

 

17,993

 

18,038

 

 

 

 

Quarter Ended

 

 

 

January 31,
2004

 

April 30,
2004

 

July 31,
2004

 

October 31,
2004

 

 

 

(unaudited)

 

 

 

(In thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

11,392

 

$

10,137

 

$

11,205

 

$

10,075

 

Gross margin

 

5,742

 

3,679

 

2,190

 

4,100

 

Loss from operations

 

(5,402

)

(9,174

)

(7,387

)

(6,610

)

Net income available (loss applicable) to common stockholders

 

(2,486

)

(14,726

)

7,501

 

(6,516

)

Net income (loss) per common share

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.18

)

$

(1.04

)

$

0.49

 

$

(0.37

)

Diluted

 

$

(0.18

)

$

(1.04

)

$

0.38

 

$

(0.37

)

Weighted average basic common shares

 

13,824

 

14,100

 

15,242

 

17,436

 

Weighted average diluted common shares

 

13,824

 

14,100

 

19,912

 

17,436

 

 

Fluctuations in Quarterly Results

 

Factors that may affect quarterly results include:

 

                  the interest level of solution providers in recommending UNIX business solutions to end users as well as the changing business attitudes toward UNIX as a viable operating system alternative to other competing systems, especially Linux;

 

                  the contingency fees we may pay to the Law Firms representing us in the SCO Litigation;

 

37



 

                  the level, magnitude and timing of SCOsource license revenue;

 

                  the amount of legal fees and related expenses incurred in connection with the SCO Litigation;

 

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

 

                  changes in general economic conditions that could affect capital expenditures in the UNIX market.

 

As a result of the factors listed above and elsewhere in the “Forward-Looking Statements and Factors That May Affect Future Results and Financial Condition” and “Risk Factors” sections of this Form 10-K, it is possible that in some future periods our results of operations may fall below management’s expectations as well as the expectations of public market analysts and investors.  If revenue falls below management’s expectations in any quarter and we are unable to reduce expenses, our operating results will be lower than expected.

 

Liquidity and Capital Resources

 

Our cash and cash equivalents balance decreased from $12,693,000 as of October 31, 2004 to $4,272,000 as of October 31, 2005.  During this same time period, our investment in available-for-sale securities decreased from $18,756,000 to $6,165,000.  Total cash and cash equivalents and available-for-sale securities were $10,437,000 as of October 31, 2005.  As of October 31, 2005, we also have $5,690,000 classified as restricted cash, of which $2,875,000 is set aside to cover expert and other costs related to our SCO Litigation and $2,815,000 is set aside for royalties payable to Novell.  During the year ended October 31, 2005, we expended a significant amount of cash in pursuit of our SCO Litigation.

 

We intend to use the cash and cash equivalents and available-for-sale securities as of October 31, 2005 to pursue our SCO Litigation and to run our UNIX business.  On November 29, 2005, we completed the sale of approximately 2,852,000 shares of our common stock in a private placement and raised gross proceeds of $10,005,000.  We believe that with the combination of our existing cash and cash equivalents and available-for-sale securities as of October 31, 2005 together with the proceeds from our recent financing that we will have sufficient cash resources to fund our current operations for at least the next 12 months.

 

Our net cash used in operating activities during the year ended October 31, 2005 was $21,507,000 and was attributable to a net loss of $10,726,000,  changes in operating assets and liabilities of $13,868,000, and offset, in part, by non-cash items of $3,087,000.  Our working capital decreased from $15,413,000 as of October 31, 2004 to $8,669,000 as of October 31, 2005.

 

Our net cash used in operating activities during the year ended October 31, 2004 was $22,604,000 and was attributable to a net loss of $23,350,000, changes in operating assets and liabilities of $176,000, and offset, in part, by non-cash items of $922,000.  Our working capital decreased from $37,168,000 as of October 31, 2003 to $15,413,000 as of October 31, 2004.

 

Our net cash provided by operating activities during the year ended October 31, 2003 was $12,087,000.  Cash provided by operations was attributable to net income of $5,427,000, non-cash items of $11,610,000 and offset, in part, by changes in operating assets and liabilities of $4,950,000.  Our long-term liabilities decreased from $1,625,000 to $508,000 during the year ended October 31, 2003.

 

Our investing activities have historically consisted of equipment purchases, investing in strategic partners and the purchase and sale of available-for-sale securities.  During the year ended October 31, 2005, cash provided by investing activities was $12,255,000, which was primarily a result of sales, net of purchases, of available-for-sale securities of $12,591,000 and the purchase of property and equipment of $336,000.

 

38



 

During the year ended October 31, 2004, cash used in investing activities was $15,443,000, which was primarily a result of purchases, net of sales, of available-for-sale securities of $14,728,000, purchases of equipment of $506,000 and the purchase of the remaining minority interest in our Japanese subsidiary of $209,000.

 

During the year ended October 31, 2003, cash used in investing activities was $5,512,000, which was primarily a result of our purchase of available-for-sale securities of $4,095,000, equipment purchases of $467,000 and our investment in non-marketable securities of $950,000.

 

Our financing activities provided $959,000 during the year ended October 31, 2005 and was comprised of proceeds of $720,000 received from the sale of common stock through our ESPP and from proceeds of $239,000 from the exercise of options to acquire shares of our common stock.

 

Our financing activities used $13,864,000 of cash during the year ended October 31, 2004.  The primary uses of cash were $13,000,000 for the repurchase and retirement of shares of our Series A-1 Convertible Preferred Stock, $2,414,000 for the purchase of shares of our common stock on the open market, and $211,000 paid in connection with the issuance of Series A-1 shares in exchange for outstanding Series A shares.  These uses of cash were offset, in part, by proceeds generated from the exercise of options to acquire common stock of $951,000 and proceeds of $810,000 received from the sale of common stock through the ESPP.

 

Our financing activities provided $50,888,000 of cash during the year ended October 31, 2003 and consisted primarily of net proceeds of $47,740,000 generated from our issuance of 50,000 now retired Series A shares.  Additional financing activities included proceeds received from the exercise of stock options of $2,056,000, proceeds from the purchase of shares of common stock by our employees through our ESPP of $236,000 and proceeds from the issuance of warrants of $856,000.

 

Our net accounts receivable balance decreased from $6,638,000 as of October 31, 2004 to $6,343,000 as of October 31, 2005, primarily as a result of lower invoicing and revenue generated during the three months ended October 31, 2005 as compared to the three months ended October 31, 2004.  The majority of our accounts receivable are current and our allowance for doubtful accounts was $144,000 as of October 31, 2005, which represented approximately 2 percent of our gross accounts receivable balance.  This percentage of gross accounts receivable is consistent with our experience in prior periods, and we expect this trend to continue.  Our write-offs of uncollectible accounts during the years ended October 31, 2005, 2004 and 2003 were not significant.

 

On October 31, 2004, we entered into the Engagement Agreement with the Law Firms.  The Engagement Agreement supercedes and replaces the original engagement agreement that was entered into in February 2003.  The Engagement Agreement governs the relationship between us and the Law Firms in connection with their representation of us in the SCO Litigation, through the end of our current litigation with IBM.  This litigation is described in more detail under Part I, Item 3 of this Form 10-K.  Our purpose in entering into this Engagement Agreement was to limit the cash expenditures needed to pursue the SCO Litigation.  The Engagement Agreement provides for the payment of approximately $26,000,000 for all attorneys’ fees in connection with the SCO Litigation through the end of our current litigation with IBM and the escrow of at least $5,000,000 for the payment of any expert, consulting and other expenses.  As of December 1, 2005, we had paid the entire $26,000,000.  As of October 31, 2005, $2,875,000 remained in the escrow account and was classified as a component of restricted cash.  In the event that we exhaust this remaining balance, we will continue to pay for expert, consulting and other expenses through the conclusion of our litigation with IBM.

 

In addition to the cash expenditures mentioned above, we must also pay one or more contingency fees upon any amount we or our stockholders may receive as a result of a settlement, judgment, or a sale of our company.  The contingency fee amounts payable to the Law Firms will be, subject to certain credits and adjustments, as follows:

 

39



 

                  33 percent of any aggregate recovery amounts received up to $350,000,000;

 

                  plus 25 percent of any aggregate recovery amounts above $350,000,000 but less than or equal to $700,000,000;

 

                  plus 20 percent of any aggregate recovery amounts in excess of $700,000,000.

 

The Engagement Agreement specifically provides that, except for the compensation obligations specifically described above, we will not be obligated to pay any legal fees, whether hourly, contingent or otherwise, to the Law Firms, or any other law firms that may be engaged by the Law Firms, in connection with the SCO Litigation through the end of the current litigation between us and IBM, including any appeals.

 

We have entered into operating leases for our corporate offices located in the United States and our international sales offices.  We have commitments under these leases that extend through the year ending October 31, 2008.

 

The following table summarizes our contractual operating lease obligations and our required payments to the Law Firms as of October 31, 2005:

 

 

 

Total

 

Less than
1 year

 

1 – 3 years

 

3 - 5 years

 

More than
5 years

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating lease obligations

 

$

3,774,000

 

$

1,797,000

 

$

1,977,000

 

$

 

$

 

Payments to Law Firms

 

2,000,000

 

2,000,000

 

 

 

 

Total obligations

 

$

5,774,000

 

$

3,797,000

 

$

1,977,000

 

$

 

$

 

 

As of October 31, 2005, we did not have any long-term debt obligations, purchase obligations, other long-term liabilities or material capital lease obligations.

 

Our ability to reduce costs to offset revenue declines in our UNIX business is limited because of contractual commitments to maintain and support our existing UNIX customers.  This decline in our UNIX business may be accelerated if industry partners withdraw their support as a result of the SCO Litigation.  In addition, the SCO Litigation may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products.  This would lead to an accelerated decline in our UNIX products and services revenue.  If our UNIX products and services revenue is less than expected, our liquidity will be adversely impacted.

 

In the event that cash required to fund operations and strategic initiatives exceeds our current cash resources and cash generated from operations, we will be required to reduce costs and perhaps raise additional capital.  We may not be able to reduce costs in a manner that does not impair our ability to maintain our UNIX business and pursue the SCO Litigation.  We may also not be able to raise capital for any number of reasons including those listed under the section “Risk Factors” under Part I, Item 1A of this Form 10-K.  If additional equity financing is available, it may not be available to us on attractive terms and may be dilutive to our existing stockholders.  In addition, if our stock price declines, we may not be able to access the public equity markets on acceptable terms, if at all.  Our ability to effect acquisitions for stock would also be impaired.

 

Recent Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards 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

 

40



 

of SFAS No. 123R are effective for our first fiscal year beginning after July 1, 2005, which will require us to adopt SFAS No. 123R for the three months ending January 31, 2006.  We believe that the adoption of SFAS No. 123R will have a material impact on our results of operations.

 

Forward-Looking Statements and Factors That May Affect Future Results and Financial Condition

 

With the exception of historical facts, the statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which reflect our current expectations and beliefs regarding our future results of operations, performance and achievements.  The section entitled “Business” above in Part I, Item 1 of this Form 10-K also includes forward-looking statements.  These statements are subject to risks and uncertainties and are based upon assumptions and beliefs that may or may not materialize.  These forward-looking statements include, but are not limited to, statements concerning:

 

                              Our intention to continue our UNIX research and development efforts while at the same time investing in Me Inc.;

 

                              Our operating strategy to continue to support our existing users of our UNIX operating system products and protect our intellectual property rights;

 

                              Our belief that our OpenServer and UnixWare products will continue to provide a revenue stream in the year ending October 31, 2006 and our belief that revenue from such products will continue to decline;

 

                              Our expectation that our sales channel should continue to provide reliable UNIX operating systems for small-to-medium sized business customers;

 

                              Our intention to focus certain UNIX development resources on augmenting our current UNIX products and our application products;

 

                              Our intention to release various Me Inc. digital services and a development toolkit;

 

                              Our belief that certain product enhancement will extend the lives and improve the functionality of our UNIX products;

 

                              Our expectation that hardware and software vendors, as well as software developments, will continue to turn their certification and application development efforts toward Linux and elect not to continue to support or certify to our UNIX operating system products;

 

                              Our intention to vigorously defend legal claims and counterclaims brought against us by others;

 

                              Our intention to continue to pursue the SCO Litigation and run our UNIX business;

 

                              Our belief that our cash balance will be adequate for us to execute our business strategy as well as to continue to pursue SCO Litigation and that we have sufficient cash reserves to fund our current operations for the next 12 months;

 

                              Our expectation that maintaining our strategic alliances with solution providers during the year ending October 31, 2006 will be critical to the success of our UNIX business and the success of our next OpenServer product;

 

                              Our intention to keep our relationships with key partners in certain vertical markets;

 

                              Our belief that our bad debts and our allowance for doubtful accounts receivable will remain consistent with our prior experience;

 

41



 

                              The strength of our intellectual property rights and contractual claims regarding UNIX generally and specifically the strength of our claim that unauthorized UNIX source code and derivatives of UNIX source code are contained in Linux;

 

                              Our expectation that total UNIX revenue for the year ending October 31, 2006 will decline from UNIX revenue generated during the year ended October 31, 2005;

 

                              Our belief that competition from Linux will continue during the year ending October 31, 2006 and future periods;

 

                              Our expectation that we will continue to be unable to predict the amount and timing of SCOsource licensing revenue, and when generated, the revenue will be sporadic;

 

                              Our expectation that future services revenue will depend in part on our ability to generate UNIX products revenue from new customers as well as the renewal of annual support and services agreements from existing UNIX customers;

 

                              Our expectation for the year ending October 31, 2006 that the dollar amount of our cost of products revenue will be lower than the dollar amount of our cost of products revenue generated during the year ended October 31, 2005;

 

                              Our expectation for the year ending October 31, 2006 that the dollar amount of our cost of SCOsource licensing revenue will be lower than that generated during the year ended October 31, 2005;

 

                              Our expectation for the year ending October 31, 2006 that the dollar amount of our cost of services revenue will be less than the dollar amount of our cost of services revenue incurred for the year ended October 31, 2005 and that cost of services revenue as a percentage of services revenue will be consistent to that generated during the year ended October 31, 2005;

 

                              Our expectation for the year ending October 31, 2006 that the dollar amount of our sales and marketing expense will decrease from that generated during the year ended October 31, 2005;

 

                              Our expectation for the year ending October 31, 2006 that the dollar amount of our research and development expense will decrease from that generated during the year ended October 31, 2005;

 

                              Our expectation for the year ending October 31, 2006 that the dollar amount of our general and administrative expense will decrease from that generated during the year ended October 31, 2005;

 

                              Our belief that our legal costs related to our intellectual property litigation will be less during the year ending October 31, 2006 compared to the year ended October 31, 2005, exclusive of any contingent payments; and

 

                              Our belief that certain legal actions to which we are a party will not have a material adverse effect on us.

 

We wish to caution readers that our operating results are subject to various risks and uncertainties that could cause our actual results and outcomes to differ materially from those discussed or anticipated, including the success of our SCO Litigation, competition from other operating systems, particularly Linux, the amount and timing of SCOsource licensing revenue, our ability to enhance our UNIX operating systems and maintain our UNIX business, and the factors set forth in the subsection entitled “Risk Factors” under Part I, item 1A of this Form 10-K.  We also wish to advise readers not to place any undue reliance on the forward-looking statements contained in this report, which reflect our beliefs and expectations only as of the date of this report.  We assume no obligation to update or revise

 

42



 

these forward-looking statements to reflect new events or circumstances or any changes in our beliefs or expectations, other than as required by law.

 

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

 

Foreign Currency Risk.  We have foreign offices and operations in Europe and Asia.  As a result, a portion of our revenue is derived from sales to customers outside the United States.  Our international revenue is denominated in U.S. dollars, Euros and United Kingdom Pounds.  Most of the operating expenses related to our foreign-based operations are denominated in foreign currencies and therefore operating results are affected by changes in the U.S. dollar exchange rate in relation to foreign currencies such as the Euro, among others.  If the U.S. dollar further weakens compared to the Euro, our operating expenses for foreign operations will be higher when translated back into U.S. dollars.  Our revenue can also be affected by general economic conditions in the United States, Europe and other international markets.  Our results of operations may be affected in the short term by fluctuations in foreign currency exchange rates.

 

Interest Rate Risk.  The primary objective of our cash management strategy is to invest available funds in a manner that assures maximum safety and liquidity and maximizes yield within such constraints.  We believe that a hypothetical movement in interest rates, either up or down, would not have a material adverse impact on our cash and cash equivalents and available-for-sale securities.  We do not borrow money for short-term investment purposes.

 

Investment Risk.  We have invested in equity instruments of privately held and public companies in the technology industry for business and strategic purposes.  Investments are accounted for under the cost method if our ownership is less than 20 percent and we are not able to exercise influence over operations.  Our investment policy is to regularly review the assumptions and operating performance of these companies and to record impairment losses when events and circumstances indicate that these investments may be impaired.  As of October 31, 2005, our investments balance totaled approximately $606,000 and consisted of our investment in a 30% owned Chinese company.

 

The stock market in general, and the market for shares of technology companies in particular, has experienced price fluctuations.  In addition, factors such as new product introductions by our competitors or developments in the SCO Litigation may have a significant impact on the market price of our common stock.  Furthermore, quarter-to-quarter fluctuations in our results of operations may have a significant impact on the market price of our common stock.  These conditions could cause the price of our common stock to fluctuate substantially over short periods of time.

 

43



 

Item 8.  Financial Statements and Supplementary Data

 

Index to Consolidated Financial Statements and Financial Statement Schedule

 

Consolidated Financial Statements:

 

Report of Independent Registered Public Accounting Firm (Tanner LC)

 

Report of Independent Registered Public Accounting Firm (KPMG LLP)

 

Consolidated Balance Sheets as of October 31, 2005 and 2004

 

Consolidated Statements of Operations and Comprehensive Income (Loss) for the years ended October 31, 2005, 2004 and 2003

 

Consolidated Statements of Stockholders’ Equity for the years ended October 31, 2005, 2004 and 2003

 

Consolidated Statements of Cash Flows for the years ended October 31, 2005, 2004 and 2003

 

Notes to Consolidated Financial Statements

 

 

 

Financial Statement Schedule:

 

Schedule II – Valuation and Qualifying Accounts

 

 

44



 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders

   The SCO Group, Inc.:

 

We have audited the consolidated balance sheet of The SCO Group, Inc. and subsidiaries as of October 31, 2005, and the related consolidated statements of operations and comprehensive loss, stockholders’ equity and cash flows for the year then ended.  Our audit also included the financial statement schedule as of and for the year ended October 31, 2005 listed in the Index at Item 8.  These financial statements and financial statement schedule are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The SCO Group, Inc. and subsidiaries as of October 31, 2005, and the consolidated results of their operations and their cash flows for the year then ended in conformity with U.S. generally accepted accounting principles.  Also in our opinion, the financial statement schedule for the related period, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

 

/s/Tanner LC

 

 

Salt Lake City, Utah

January 23, 2006

 

45



 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of

   The SCO Group, Inc.:

 

We have audited the consolidated balance sheet of The SCO Group, Inc. and subsidiaries as of October 31, 2004, and the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity and cash flows for the years ended October 31, 2004 and 2003.  In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule for the related periods.  These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The SCO Group, Inc. and subsidiaries as of October 31, 2004, and the results of their operations and their cash flows for the years ended October 31, 2004 and 2003 in conformity with accounting principles generally accepted in the United States of America.  Also in our opinion, the financial statement schedule for the related periods, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

 

/s/KPMG LLP

 

 

Salt Lake City, Utah

February 18, 2005

except as to Note 16,

which is as of March 11, 2005

 

46



 

 

 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

 

 

October 31,

 

 

 

2005

 

2004

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

CURRENT ASSETS:

 

 

 

 

 

Cash and cash equivalents

 

$

4,272

 

$

12,693

 

Restricted cash

 

5,690

 

8,283

 

Available-for-sale securities

 

6,165

 

18,756

 

Accounts receivable, net of allowance for doubtful accounts of $144 and $136, respectively

 

6,343

 

6,638

 

Other current assets

 

2,454

 

1,870

 

Total current assets

 

24,924

 

48,240

 

 

 

 

 

 

 

PROPERTY AND EQUIPMENT:

 

 

 

 

 

Computer and office equipment

 

2,224

 

2,991

 

Leasehold improvements

 

345

 

406

 

Furniture and fixtures

 

96

 

103

 

 

 

2,665

 

3,500

 

Less accumulated depreciation and amortization

 

(2,087

)

(2,851

)

Net property and equipment

 

578

 

649

 

 

 

 

 

 

 

OTHER ASSETS:

 

 

 

 

 

Intangibles, net

 

2,707

 

5,413

 

Other assets

 

739

 

1,098

 

Total other assets

 

3,446

 

6,511

 

 

 

 

 

 

 

Total assets

 

$

28,948

 

$

55,400

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY