10-Q 1 a06-9978_110q.htm QUARTERLY REPORT PURSUANT TO SECTIONS 13 OR 15(D)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

(Mark one)

x        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended April 30, 2006

OR

 

o        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                      

 

Commission file number 0-29911

 

THE SCO GROUP, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

87-0662823

(State or other jurisdiction of

(I.R.S. Employer Identification Number)

incorporation or organization)

 

 

355 South 520 West

Suite 100

Lindon, Utah 84042

(Address of principal executive offices and zip code)

 

(801) 765-4999

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES x NO o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):  Large Accelerated Filer o Accelerated filer o Non-accelerated Filer x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  (Check one):  YES o NO x

 

As of June 9, 2006, there were 21,090,757 shares of the Registrant’s common stock, $0.001 par value per share, outstanding.

 

 



 

The SCO Group, Inc.

 

Table of Contents

 

 

PART I.

FINANCIAL INFORMATION

 

Item 1.

Unaudited Financial Statements

 

 

Condensed Consolidated Balance Sheets as of April 30, 2006 and October 31, 2005

 

 

Condensed Consolidated Statements of Operations and Comprehensive Loss for the three and six months ended April 30, 2006 and 2005

 

 

Condensed Consolidated Statements of Cash Flows for the six months ended April 30, 2006 and 2005

 

 

Notes to Condensed Consolidated Financial Statements

 

Item 2.

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

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

Item 4.

Controls and Procedures

 

PART II.

OTHER INFORMATION

 

Item 1.

Legal Proceedings

 

Item 1A.

Risk Factors

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

Item 6.

Exhibits

 

 

Signatures

 

 

2



 

PART I.          FINANCIAL INFORMATION

ITEM 1.          UNAUDITED FINANCIAL STATEMENTS

 

 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

 

 

 

April 30,

 

October 31,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

CURRENT ASSETS:

 

 

 

 

 

Cash and cash equivalents

 

$

9,524

 

$

4,272

 

Restricted cash

 

3,340

 

5,690

 

Available-for-sale marketable securities

 

9,100

 

6,165

 

Accounts receivable, net of allowance for doubtful accounts of  $119 and $144, respectively

 

5,109

 

6,343

 

Other

 

1,728

 

2,454

 

Total current assets

 

28,801

 

24,924

 

 

 

 

 

 

 

PROPERTY AND EQUIPMENT:

 

 

 

 

 

Computer and office equipment

 

2,110

 

2,224

 

Leasehold improvements

 

289

 

345

 

Furniture and fixtures

 

70

 

96

 

 

 

2,469

 

2,665

 

Less accumulated depreciation and amortization

 

(1,894

)

(2,087

)

Net property and equipment

 

575

 

578

 

 

 

 

 

 

 

OTHER ASSETS:

 

 

 

 

 

Definite-lived intangibles, net

 

1,353

 

2,707

 

Other

 

732

 

739

 

Total other assets

 

2,085

 

3,446

 

 

 

 

 

 

 

Total assets

 

$

31,461

 

$

28,948

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

CURRENT LIABILITIES:

 

 

 

 

 

Accounts payable

 

$

3,669

 

$

2,197

 

Payable to Novell, Inc.

 

3,200

 

2,815

 

Accrued payroll and benefits

 

2,072

 

2,656

 

Accrued liabilities

 

3,208

 

3,118

 

Deferred revenue

 

3,383

 

3,841

 

Royalties payable

 

281

 

406

 

Income taxes payable

 

1,295

 

1,222

 

Total current liabilities

 

17,108

 

16,255

 

 

 

 

 

 

 

LONG-TERM LIABILITIES

 

265

 

338

 

 

 

 

 

 

 

COMMITMENTS AND CONTINGENCIES (Note 4)

 

 

 

 

 

 

 

 

 

 

 

COMMON STOCK SUBJECT TO RESCISSION (Note 5)

 

 

1,018

 

 

 

 

 

 

 

STOCKHOLDERS’ EQUITY:

 

 

 

 

 

Common stock, $0.001 par value; 45,000 shares authorized,  21,299 and 18,331 shares outstanding, respectively

 

21

 

18

 

Additional paid-in capital

 

258,975

 

246,985

 

Common stock held in treasury; 297 and 290 shares, respectively

 

(2,446

)

(2,414

)

Warrants outstanding

 

856

 

856

 

Accumulated other comprehensive income

 

899

 

834

 

Accumulated deficit

 

(244,217

)

(234,942

)

Total stockholders’ equity

 

14,088

 

11,337

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

31,461

 

$

28,948

 

 

See accompanying notes to condensed consolidated financial statements.

 

3



 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(in thousands, except per share data)

 

 

 

Three Months Ended April 30,

 

Six Months Ended April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

REVENUE:

 

 

 

 

 

 

 

 

 

Products

 

$

5,703

 

$

7,838

 

$

11,703

 

$

15,142

 

SCOsource licensing

 

34

 

30

 

64

 

100

 

Services

 

1,389

 

1,390

 

2,702

 

2,881

 

Total revenue

 

7,126

 

9,258

 

14,469

 

18,123

 

 

 

 

 

 

 

 

 

 

 

COST OF REVENUE:

 

 

 

 

 

 

 

 

 

Products

 

497

 

563

 

1,081

 

1,207

 

SCOsource licensing

 

3,762

 

2,889

 

7,772

 

6,382

 

Services

 

709

 

746

 

1,346

 

1,495

 

Total cost of revenue

 

4,968

 

4,198

 

10,199

 

9,084

 

 

 

 

 

 

 

 

 

 

 

GROSS MARGIN

 

2,158

 

5,060

 

4,270

 

9,039

 

 

 

 

 

 

 

 

 

 

 

OPERATING EXPENSES:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

2,857

 

2,970

 

5,545

 

5,914

 

Research and development

 

1,886

 

2,117

 

3,757

 

4,205

 

General and administrative

 

1,718

 

2,036

 

3,310

 

3,799

 

Amortization of intangibles

 

593

 

593

 

1,185

 

1,186

 

Total operating expenses

 

7,054

 

7,716

 

13,797

 

15,104

 

 

 

 

 

 

 

 

 

 

 

LOSS FROM OPERATIONS

 

(4,896

)

(2,656

)

(9,527

)

(6,065

)

 

 

 

 

 

 

 

 

 

 

EQUITY IN INCOME (LOSS) OF AFFILIATE

 

 

17

 

(8

)

70

 

 

 

 

 

 

 

 

 

 

 

OTHER INCOME, NET:

 

 

 

 

 

 

 

 

 

Interest income

 

199

 

98

 

351

 

135

 

Other income, net

 

117

 

702

 

110

 

1,174

 

Total other income, net

 

316

 

800

 

461

 

1,309

 

 

 

 

 

 

 

 

 

 

 

LOSS BEFORE PROVISION FOR INCOME TAXES

 

(4,580

)

(1,839

)

(9,074

)

(4,686

)

 

 

 

 

 

 

 

 

 

 

PROVISION FOR INCOME TAXES

 

(114

)

(123

)

(201

)

(237

)

 

 

 

 

 

 

 

 

 

 

NET LOSS

 

$

(4,694

)

$

(1,962

)

$

(9,275

)

$

(4,923

)

 

 

 

 

 

 

 

 

 

 

BASIC AND DILUTED NET LOSS PER COMMON SHARE

 

$

(0.22

)

$

(0.11

)

$

(0.45

)

$

(0.28

)

 

 

 

 

 

 

 

 

 

 

WEIGHTED AVERAGE BASIC AND DILUTED COMMON SHARES OUTSTANDING

 

20,994

 

17,913

 

20,520

 

17,831

 

 

 

 

 

 

 

 

 

 

 

OTHER COMPREHENSIVE LOSS:

 

 

 

 

 

 

 

 

 

Net loss

 

$

(4,694

)

$

(1,962

)

$

(9,275

)

$

(4,923

)

Unrealized gain on available-for-sale marketable securities

 

11

 

12

 

45

 

9

 

Foreign currency translation adjustment

 

26

 

(58

)

20

 

4

 

COMPREHENSIVE LOSS

 

$

(4,657

)

$

(2,008

)

$

(9,210

)

$

(4,910

)

 

See accompanying notes to condensed consolidated financial statements.

 

4



 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net loss

 

$

 (9,275

)

$

(4,923

)

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

 

 

 

 

 

Amortization of intangibles (including $169 and $167 classified as cost of SCOsource licensing revenue)

 

1,354

 

1,353

 

Depreciation and amortization

 

148

 

184

 

Stock-based compensation

 

833

 

22

 

Loss on disposal of assets

 

7

 

32

 

Equity in (income) loss of affiliate

 

8

 

(70

)

Changes in operating assets and liabilities:

 

 

 

 

 

Restricted cash

 

2,735

 

1,033

 

Accounts receivable, net

 

1,234

 

313

 

Other current assets

 

726

 

(418

)

Other assets

 

(1

)

34

 

Accounts payable

 

1,472

 

(6,430

)

Accrued payroll and benefits

 

(584

)

(608

)

Compensation to law firms

 

 

(7,956

)

Accrued liabilities

 

90

 

(249

)

Deferred revenue

 

(458

)

19

 

Royalties payable

 

(125

)

(45

)

Income taxes payable

 

73

 

8

 

Other long-term liabilities

 

(73

)

(1

)

Net cash used in operating activities

 

(1,836

)

(17,702

)

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Purchase of property and equipment

 

(153

)

(145

)

Purchase of available-for-sale marketable securities

 

(6,435

)

(8,200

)

Proceeds from sale of available-for-sale marketable securities

 

3,500

 

20,909

 

Net cash (used in) provided by investing activities

 

(3,088

)

12,564

 

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from sale of common stock through employee stock purchase plan

 

301

 

373

 

Proceeds from exercise of common stock options

 

32

 

205

 

Repurchase of common stock

 

(32

)

 

Proceeds from sale of common stock in a private placement, net of offering costs

 

9,809

 

 

Net cash provided by financing activities

 

10,110

 

578

 

 

 

 

 

 

 

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

 

5,186

 

(4,560

)

EFFECT OF FOREIGN EXCHANGE RATES ON CASH AND CASH EQUIVALENTS

 

66

 

12

 

CASH AND CASH EQUIVALENTS, beginning of period

 

4,272

 

12,693

 

CASH AND CASH EQUIVALENTS, end of period

 

$

 9,524

 

$

8,145

 

 

 

 

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

 

 

 

 

 

 

 

 

 

 

 

Cash paid for income taxes

 

$

 138

 

$

248

 

 

 

 

 

 

 

SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES:

 

 

 

 

 

 

 

 

 

 

 

Increase (decrease) in common stock subject to rescission

 

$

 (1,018

)

$

323

 

 

See accompanying notes to condensed consolidated financial statements.

 

5



 

THE SCO GROUP, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

(1) ORGANIZATION AND DESCRIPTION OF BUSINESS

The business of The SCO Group, Inc. (the “Company”, “we”, “us” or “our”) focuses on marketing reliable, cost-effective UNIX software products and related services for the small-to-medium sized business market, including replicated site franchises of Fortune 1000 companies.  The Company has operations in a number of countries that provide support services to customers and resellers. During the year ended October 31, 2003, the Company initiated its SCOsource business to protect and defend its UNIX intellectual property.  The Company acquired certain intellectual property rights surrounding UNIX and UNIX System V source code from The Santa Cruz Operation, which changed its name to Tarantella, Inc., and was subsequently acquired by Sun Microsystems, in May 2001.

In its efforts to protect and defend its intellectual property rights, the Company incurred a net loss of $9,275,000 for the six months ended April 30, 2006 and during that same period, the Company used cash of $1,836,000 in its operating activities.  As of April 30, 2006, the Company had a total of $9,524,000 in cash and cash equivalents, $9,100,000 in available-for-sale marketable securities, and $3,340,000 in restricted cash, of which $140,000 is designated to pay for experts, consultants and other expenses in the SCO Litigation (as defined herein), and the remaining $3,200,000 of restricted cash is payable to Novell for its retained binary royalty stream.  On June 5, 2006, the Company entered into an amendment to the Engagement Agreement with Boies, Schiller & Flexner LLP, Kevin McBride and Berger Singerman (the “Law Firms”) and agreed to deposit an additional $5,000,000 into the escrow account to cover future expert, consulting and other expenses.

(2) SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) on a basis consistent with the Company’s audited annual financial statements, and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial information set forth therein.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to SEC rules and regulations, although the Company believes that the following disclosures, when read in conjunction with the audited annual financial statements and the notes thereto included in the Company’s most recent annual report on Form 10-K, are adequate to make the information presented not misleading.  Operating results for the three and six months ended April 30, 2006 are not necessarily indicative of the operating results that may be expected for the year ending October 31, 2006.

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the

 

6



date of the financial statements and the reported amounts of revenue and expenses during the reporting periods.  Actual results could differ from these estimates.  The Company’s critical accounting policies and estimates include, among others, revenue recognition, allowances for doubtful accounts receivable,  impairment and useful lives of long-lived assets, litigation reserves, and valuation allowances against deferred income tax assets.

Revenue Recognition

The Company recognizes revenue in accordance with Statement of Position (“SOP”) 97-2, as modified by SOP 98-9.  The Company’s revenue has historically been from three sources: (i) product license revenue, primarily from product sales to resellers, end users and original equipment manufacturers (“OEMs”); (ii) technical support service revenue, primarily from providing technical support and consulting services to end users; and (iii) revenue from SCOsource licensing.

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

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

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

The Company considers an arrangement with payment terms longer than the Company’s normal business practice not to be fixed or determinable, and revenue is recognized when the fee becomes due.  The Company typically provides stock rotation rights for sales made through its distribution channel and sales to distributors are recognized upon shipment by the distributor to end users.  For direct sales not through the Company’s distribution channel, sales are typically non-refundable and non-cancelable.  The Company estimates its product returns based on historical experience and maintains an allowance for estimated returns, which is recorded as a reduction to accounts receivable.

The Company’s SCOsource revenue to date has been primarily generated from agreements to utilize the Company’s UNIX source code as well as from intellectual property compliance agreements.  The Company recognizes revenue from SCOsource agreements when a signed contract exists, the fee is fixed or determinable, collection of the receivable is probable and delivery has occurred.  If the payment terms extend beyond the Company’s normal payment terms, revenue is recognized as the payments become due.

Cash and Cash Equivalents

7



The Company considers all investments purchased with original maturities of three months or less to be cash equivalents.  Cash equivalents were $5,816,000 and $1,528,000 as of April 30, 2006 and October 31, 2005, respectively.  Cash was $3,708,000 and $2,744,000 as of April 30, 2006 and October 31, 2005, respectively.

Available-for-Sale Marketable Securities

Available-for-sale marketable securities are recorded at fair market value, based on quoted market prices, and unrealized gains and losses are recorded as a component of comprehensive loss.  Realized gains and losses, which are calculated based on the specific-identification method, are recorded in operations as incurred.

                Available-for-sale marketable securities totaled $9,100,000 as of April 30, 2006.  Any available-for-sale marketable securities in an unrealized loss position as of April 30, 2006 were not impaired at acquisition and the decline in fair value is primarily attributable to interest rate fluctuations.  A decline in the market value of any available-for-sale marketable security below cost that is deemed other than temporary results in a charge to earnings and establishes a new basis for the security.

Net Loss per Common Share

Basic net loss per common share (“Basic EPS”) is computed by dividing net loss by the weighted average number of common shares outstanding.  Diluted net income per common share (“Diluted EPS”), if any, is computed by dividing net income by the sum of the weighted average number of common shares outstanding and the dilutive potential common share equivalents then outstanding.  Potential common share equivalents consist of the weighted average number of shares issuable upon the exercise of outstanding stock options and warrants to acquire common stock.  If dilutive, the Company computes Diluted EPS using the treasury stock method.

The excluded anti-dilutive common share equivalents of 4,981,000 and 3,696,000 for the three and six months ended April 30, 2006 and 2005, respectively, are not included in the computation of Diluted EPS as their effect would have decreased Diluted EPS.

(3) DEFINITE-LIVED INTANGIBLE ASSETS

The following table shows the activity related to definite-lived intangible assets for the six months ended April 30, 2006 as well as the remaining unamortized balances as of April 30, 2006 (in thousands):

 

 

As of
October 31, 2005

 

Six Months
Ended
April 30, 2006

 

As of
April 30, 2006

 

 

 

Carrying Value

 

Amortization
Expense

 

Carrying Value

 

Definite-lived intangible assets:

 

 

 

 

 

 

 

Distribution/reseller channel

 

$

2,318

 

$

(1,159

)

$

1,159

 

Acquired technology

 

337

 

(169

)

168

 

Trade name

 

52

 

(26

)

26

 

Total definite-lived intangible assets

 

$

2,707

 

$

(1,354

)

$

1,353

 

 

Of the $1,354,000 in amortization expense for the six months ended April 30, 2006, $1,185,000 was classified as amortization of intangible assets in operating expenses and the remaining $169,000 was classified as cost of SCOsource licensing revenue.

8



(4) COMMITMENTS AND CONTINGENCIES

Litigation

IBM Corporation

On or about March 6, 2003, the Company 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, the Company claims, 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.  The Company’s complaint includes, among other things, claims for breach of contract, unfair competition, tortious interference and copyright infringement.  As a result of IBM’s actions, the Company is requesting damages in an amount to be proven at trial and seeking injunctive relief.

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

                On February 27, 2004, the Company 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 the Company does not have the right to terminate IBM’s UNIX license and IBM has claimed that the Company has breached the GNU General Public License and has infringed certain patents held by IBM.  IBM’s counterclaims include claims for breach of contract, violation of the Lanham Act, unfair competition, intentional interference with prospective economic relations, unfair and deceptive trade practices, 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 the Company’s contract claims, on IBM’s eighth counterclaim for copyright infringement, and on IBM’s tenth counterclaim for a declaration of non-infringement of the Company’s copyrights.  The court denied each of those motions without prejudice to IBM’s renewing or refiling the motions after discovery is complete.  The court also denied the Company’s motion to stay or dismiss IBM’s tenth counterclaim.  The court ordered that no further dispositive motions could be filed until the close of discovery.

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.

9



Pursuant to the court’s July 1, 2005 Scheduling Order, the Company filed its Interim Disclosure of Material Misused by IBM on October 28, 2005.  The Company’s report included a matrix that identifies 217 separate technology disclosures that it contends IBM improperly made to enhance Linux in violation of one or more contractual prohibitions governing IBM’s use of the Company’s proprietary material.  The Company 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 the Company’s proprietary material.  The Company’s December 22, 2005 report included 294 total disclosures which the Company claims violate its contractual rights and copyrights.  These reports and the disclosures identified are the result of analysis from experienced outside technical consultants.

On February 13, 2006, IBM filed a motion with the court seeking to limit the Company’s claims.  IBM argues that of the 294 items identified by the Company in the December 22, 2005 filing, 201 did not meet the level of specificity required by the court.  IBM requested that the Company be limited to 93 items set forth in the December 22, 2005 filing which IBM claims meet the required level of specificity.  The Company disagrees with IBM’s motion and analysis and filed an opposition brief under seal with the court.  The court heard arguments on the matter on April 14, 2006 and took the matter under advisement.  On June 8, 2006, IBM filed a motion to confine the Company’s claims to, and strike allegations in excess of, the final disclosures.  In this motion, IBM claims that the Company’s technology expert reports go beyond the disclosures contained in the Company’s December 22, 2005 submission to the court and that those expert reports should be stricken to that extent.  Discovery is ongoing in the case as the parties prepare for trial.

Novell, Inc.

On January 20, 2004, the Company filed suit in Utah state court against Novell, Inc. for slander of title seeking relief for its alleged bad faith effort to interfere with the Company’s ownership of copyrights related to the Company’s UNIX source code and derivative works and the Company’s UnixWare product.  The case is pending in the United States District Court for the District of Utah under the caption, The SCO Group, Inc. v. Novell, Inc., Civil No. 2:04CV00139.  In the lawsuit, the Company requested preliminary and permanent injunctive relief as well as damages.  Through these claims, the Company seeks to require Novell to assign to the Company all copyrights that the Company believes Novell has wrongfully registered, prevent Novell from representing any ownership interest in those copyrights and require Novell to retract or withdraw all representations it has made regarding its purported ownership of those copyrights and UNIX itself.

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 the Company, asserting counterclaims for the Company’s alleged breaches of the Asset Purchase Agreement between Novell and the Company’s predecessor-in-interest, The Santa Cruz Operation, Inc., for slander of title, restitution/unjust enrichment, an accounting related to Novell’s retained binary royalty stream, 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, the Company filed a motion for leave to amend its complaint to assert additional claims against Novell including copyright infringement, unfair competition and a breach of Novell’s limited license to use the Company’s UNIX code.  Novell has consented to the Company’s filing of these additional claims.

10



On or about April 10, 2006, Novell filed a motion to stay the case in Utah pending a request for arbitration that Novell filed on the same date in the International Court of Arbitration in France.  Through these proceedings, Novell claims that the Company granted Novell the right to use its intellectual property through the Company’s participation in the United Linux initiative in 2002.  Through its acquisition of SUSE Linux, GmbH, Novell claims it acquired all rights SUSE had as a member of United Linux.  On May 26, 2006, the Company filed a response to Novell’s motion to stay and the Company will respond to Novell’s request for arbitration in due course.  No hearing on Novell’s motion has been scheduled.  Discovery is commencing in the case.

AutoZone, Inc.

On or about March 2, 2004, the Company brought suit against AutoZone, Inc. for its alleged violations of the Company’s UNIX copyrights through its use of Linux.  The lawsuit alleges copyright infringement by AutoZone by, among other things, running versions of the Linux operating system that contain proprietary material from UNIX System V.  The lawsuit, filed in United States District Court in Nevada, requests injunctive relief against AutoZone’s further use or copying of any part of the Company’s copyrighted materials and also requests damages as a result of AutoZone’s infringement in an amount to be proven at trial.  In response to AutoZone’s motion to transfer the case to Tennessee or stay the case, the federal court in Nevada granted AutoZone’s motion to stay the case, with 90-day status reports to the court, and denied without prejudice AutoZone’s motion to transfer the case to Tennessee.  The court allowed the parties to take limited expedited discovery relating to the issue of preliminary injunctive relief which discovery was concluded in May 2005.

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

IPO Class Action Matter

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

The plaintiffs, the issuers and the insurance companies have negotiated an agreement to settle the dispute between the plaintiffs and the issuers.  All parties, including the plaintiffs, issuers and insurance companies, have executed this settlement agreement and the settlement agreement has been submitted to the court for approval.  If the settlement agreement is approved by the court, and if no cross-claims, counterclaims or third-party claims are later asserted, this action will be dismissed with respect to the Company and its directors.

11



The Company has notified its underwriters and insurance companies of the existence of the claims.  Management believes, after consultation with legal counsel, that the ultimate outcome of this matter will not have a material adverse effect on the Company’s results of operations or financial position and will not exceed the $200,000 self-insured retention already paid or accrued by the Company.

Red Hat, Inc.

On August 4, 2003, Red Hat, Inc. filed a complaint against the Company.  The action is pending in the United States District Court for the District of Delaware under the case caption, Red Hat, Inc. v. The SCO Group, Inc., Civil No. 03-772.  Red Hat asserts that the Linux operating system does not infringe on the Company’s UNIX intellectual property rights and seeks a declaratory judgment for non-infringement of copyrights and no misappropriation of trade secrets.  In addition, Red Hat claims the Company has engaged in false advertising in violation of the Lanham Act, deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, trade libel and disparagement.  On April 6, 2004, the court denied the Company’s motion to dismiss this case; however, the court stayed the case and requested status reports every 90 days regarding the case against IBM.  Red Hat filed a motion for reconsideration, which the court denied on March 31, 2005.  The Company intends to vigorously defend this action.  In the event the stay is lifted and Red Hat is allowed to pursue its claims, the Company will likely assert counterclaims against Red Hat.

Other Matters

In April 2003, the Company’s former Indian distributor filed a claim in India, requesting summary judgment for payment of approximately $1,428,000, and an order that the Company trade in India only through the distributor and/or give a security deposit until the claim is paid.  The distributor claims that the Company is responsible to repurchase certain software products and to reimburse the distributor for certain other operating costs.  Management does not believe that the Company is responsible to reimburse the distributor for any operating costs and also believes that the return rights related to any remaining inventory have lapsed.  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.  The Company intends to vigorously defend this action.

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

The ultimate outcome or potential negative effect on the Company’s results of operations or financial position of the Red Hat, Inc., IPO Class Action, Indian Distributor matter, or IBM or Novell counterclaims is neither probable nor estimable.

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

(5) COMMON STOCK SUBJECT TO RESCISSION

The Company believes certain shares and options granted under its Equity Compensation Plans were issued without complying with registration or qualification requirements under federal securities laws and the securities laws of certain states.  As a result, certain Plan participants had a right to rescind their purchases of shares under the Plans or recover damages if they no longer own the shares or hold unexercised options, subject to

12



applicable statutes of limitations.  Additionally, regulatory authorities may require the Company to pay fines or impose other sanctions.

Accounting Series Release (“ASR”) No. 268 and Emerging Issues Task Force (“EITF”) Topic D-98 require that stock subject to rescission or redemption requirements outside the control of the Company to be classified outside of permanent equity.  The exercise of the rescission right is at the holders’ discretion, but exercise of that right may depend in part on the fair value of the Company’s common stock, which is outside of the Company’s and the holders’ control.  Consequently, common stock subject to rescission is classified as temporary equity.

In December 2005, the Company offered to rescind a total of 337,289 shares of common stock issued under its 2000 Employee Stock Purchase Plan (the “ESPP”) to current and former employees while they resided in any of California, Connecticut, Illinois, New Jersey, Utah, Texas or Washington.  These shares represented all of the ESPP shares the Company issued to residents of these states for which a purchaser could claim a rescission right.  The rescission offer was intended to address the Company’s rescission liability relating to its 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 the Company or recover damages, as the case may be.

The rescission offer concluded on January 20, 2006.  As of that date, 14 offerees accepted the Company’s offer to rescind the purchase of approximately 7,300 shares.  The Company made aggregate payments to such offerees of approximately $41,500, which included approximately $31,800 for the purchase of the shares and approximately $9,700 in statutory interest and damages.  As a result of the rescission offer, the Company believes it has extinguished its state rescission liability and mitigated its 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 the ESPP.  Upon the close of the rescission offer, the Company reclassified the remainder of the common stock subject to rescission which totaled $1,018,000 as additional paid-in capital in permanent equity.

(6) STOCKHOLDERS’ EQUITY

Issuance of Common Stock

On November 29, 2005, the Company entered into a Common Stock Purchase Agreement (“Purchase Agreement”) with several institutional investors and one member of the Company’s board of directors.  On November 30, 2005, the Company sold to the investors approximately 2,852,000 shares of the Company’s common stock for gross proceeds of approximately $10,005,000.  Through April 30, 2006, the costs to facilitate the private placement of the common stock were approximately $196,000.  The shares issued to the institutional investors were issued at $3.50 per share and the shares issued to the board member were issued at $3.92 per share.  Pursuant to the Purchase Agreement, the Company agreed to use its best efforts to file a registration statement with the SEC covering the resale of this common stock, and to use its commercially reasonable efforts to have such registration statement declared effective.   On December 22, 2005, the Company filed a registration statement with the Securities and Exchange Commission.  On March 1, 2006, the Company filed pre-effective amendment number one to this registration statement, and on May 2, 2006, the Company filed pre-effective amendment number two to this registration statement.  On May 25, 2006, this registration statement was declared effective by the SEC.

Equity Plans

13



The Company has established the 1998 Stock Option Plan (the “1998 Plan”), 1999 Omnibus Stock Incentive Plan (the “1999 Plan”), the 2002 Omnibus Stock Incentive Plan (the “2002 Plan”) and the 2004 Omnibus Stock Incentive Plan (the “2004 Plan”) for the award of stock options, stock appreciation rights, restricted stock, phantom stock rights, and stock bonuses to employees, executive officers, members of the Board of Directors and outside consultants.  The Compensation Committee of the Board of Directors has the ability to determine the terms of the option, the exercise price, the number of shares subject to each option, and the exercisability of the options.  Under the terms of the 1998, 1999, 2002 and 2004 Plans, options generally expire 10 years from the date of grant or within 90 days of termination.  Options granted under these plans generally vest at 25 percent after the completion of one year of service and then 1/36 per month for the remaining three years and are fully vested at the end of four years.   Pursuant to the terms of their grant agreements, certain of the options granted under these plans may be subject to accelerated vesting upon a change in control of the Company.

The Company has also established the ESPP, which is designed to allow eligible employees of the Company and its participating subsidiaries to purchase shares of the Company’s common stock, at semi-annual intervals, through periodic payroll deductions.

Prior to October 31, 2005, as permitted under Statement of Financial Accounting Standards (“SFAS”) No. 123, the Company accounted for its stock option plans following the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock issued to Employees,” and related interpretations.  Accordingly, no stock-based compensation expense had been reflected in the Company’s statements of operations as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant and the related number of shares granted was fixed at that point in time.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), “Share Based Payment.”  This statement revised SFAS No. 123 by eliminating the option to account for employee stock options under APB No. 25 and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards.

Effective November 1, 2005, the Company adopted the fair value recognition provisions of SFAS No. 123(R) using the modified prospective application method.  Under this transition method, the Company recorded compensation expense on a straight-line basis for the three and six months ended April 30, 2006, for: (a) the vesting of options granted prior to November 1, 2005 (based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and previously presented in the pro-forma footnote disclosures), and (b) stock-based awards granted subsequent to November 1, 2005 (based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R)).  In accordance with the modified prospective application method, results for the three and six months ended April 30, 2005 have not been restated.

The effect of accounting for stock-based awards under SFAS No. 123(R) for the three and six months ended April 30, 2006 was to record $432,000 and $833,000, respectively, of stock-based compensation expense.  For the three and six months ended April 30, 2006 and 2005, the Company has allocated stock-based compensation expense to the following statement of operations and comprehensive loss captions:

 

 

Three Months Ended April 30,

 

Six Months Ended April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Cost of products

 

$

5,000

 

$

 

$

7,000

 

$

 

Cost of SCOsource licensing

 

57,000

 

 

110,000

 

 

Cost of services

 

16,000

 

 

29,000

 

 

Sales and marketing

 

91,000

 

7,000

 

159,000

 

14,000

 

Research and development

 

36,000

 

 

56,000

 

8,000

 

General and administrative

 

227,000

 

 

472,000

 

 

Total stock-based compensation expense

 

$

432,000

 

$

7,000

 

$

833,000

 

$

22,000

 

 

14



The following pro-forma information, as required by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123,” is presented for comparative purposes and illustrates the effect on net loss and net loss per common share for the three and six months ended April 30, 2005 as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation prior to November 1, 2005 (in thousands):

 

 

Three Months Ended
April 30, 2005

 

Six Months Ended
April 30, 2005

 

Net loss:

 

 

 

 

 

As reported

 

$

(1,962

)

$

(4,923

)

Stock-based compensation included in reported net loss

 

7

 

22

 

Stock-based compensation under fair value method

 

(403

)

(597

)

Pro forma net loss

 

$

(2,358

)

$

(5,498

)

Net loss per basic and diluted common share:

 

 

 

 

 

As reported

 

$

(0.11

)

$

(0.28

)

Pro forma

 

$

(0.13

)

$

(0.31

)

 

With respect to stock options granted during the three and six months ended April 30, 2006 and 2005, the assumptions used in the Black-Scholes option-pricing model are as follows: 

 

 

Three Months Ended April 30,

 

Six Months Ended April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Risk-free interest rate

 

4.9

%

3.7

%

4.7

%

3.6

%

Expected dividend yield

 

0.0

%

0.0

%

0.0

%

0.0

%

Volatility

 

61.1

%

51.5

%

62.1

%

72.4

%

Expected exercise life (in years)

 

5.0

 

2.7

 

5.0

 

2.7

 

 

The estimated fair value of stock options and ESPP shares are amortized over the vesting period of the award.

During the six months ended April 30, 2006, the Company granted options to purchase approximately 962,000 shares of common stock with an average exercise price of $3.92 per share.  None of these stock options were granted with an exercise price below the quoted market price on the date of grant.  During the six months ended April 30, 2006, options to purchase approximately 27,000 shares of common stock were exercised with an average exercise price of $1.20 per share.  As of April 30, 2006, there were approximately 4,746,000 stock options outstanding with a weighted average exercise price of $4.13 per share.

(7) CONCENTRATION OF CREDIT RISK

As of April 30, 2006 and October 31, 2005, the Company had no customers who made up more than 10 percent of the accounts receivable balance.

During the three and six months ended April 30, 2006 and 2005, no single customer accounted for more than 10 percent of total revenue.

(8) SEGMENT INFORMATION

15



The Company’s resources are allocated and operating results managed to the operating income (loss) level for each of the Company’s segments: UNIX and SCOsource.  Both segments are based on the Company’s UNIX intellectual property.  The UNIX business sells and distributes UNIX products and services through an extensive distribution channel and to corporate end-users and the SCOsource business enforces and protects the Company’s UNIX intellectual property.  Segment disclosures for the Company are as follows (in thousands):

 

 

Three Months Ended April 30, 2006

 

 

 

UNIX

 

SCOsource

 

Total

 

 

 

 

 

 

 

 

 

Revenue

 

$

7,092

 

$

34

 

$

7,126

 

Cost of revenue

 

1,206

 

3,762

 

4,968

 

Gross margin (deficit)

 

5,886

 

(3,728

)

2,158

 

Sales and marketing

 

2,856

 

1

 

2,857

 

Research and development

 

1,792

 

94

 

1,886

 

General and administrative

 

1,681

 

37

 

1,718

 

Amortization of intangibles

 

593

 

 

593

 

Total operating expenses

 

6,922

 

132

 

7,054

 

Loss from operations

 

$

(1,036

)

$

(3,860

)

$

(4,896

)

 

 

 

Three Months Ended April 30, 2005

 

 

 

UNIX

 

SCOsource

 

Total

 

 

 

 

 

 

 

 

 

Revenue

 

$

9,228

 

$

30

 

$

9,258

 

Cost of revenue

 

1,309

 

2,889

 

4,198

 

Gross margin (deficit)

 

7,919

 

(2,859

)

5,060

 

Sales and marketing

 

2,963

 

7

 

2,970

 

Research and development

 

2,027

 

90

 

2,117

 

General and administrative

 

1,866

 

170

 

2,036

 

Amortization of intangibles

 

593

 

 

593

 

Total operating expenses

 

7,449

 

267

 

7,716

 

Income (loss) from operations

 

$

470

 

$

(3,126

)

$

(2,656

)

 

 

 

Six Months Ended April 30, 2006

 

 

 

UNIX

 

SCOsource

 

Total

 

 

 

 

 

 

 

 

 

Revenue

 

$

14,405

 

$

64

 

$

14,469

 

Cost of revenue

 

2,427

 

7,772

 

10,199

 

Gross margin (deficit)

 

11,978

 

(7,708

)

4,270

 

Sales and marketing

 

5,544

 

1

 

5,545

 

Research and development

 

3,569

 

188

 

3,757

 

General and administrative

 

3,213

 

97

 

3,310

 

Amortization of intangibles

 

1,185

 

 

1,185

 

Total operating expenses

 

13,511

 

286

 

13,797

 

Loss from operations

 

$

(1,533

)

$

(7,994

)

$

(9,527

)

 

16



 

 

Six Months Ended April 30, 2005

 

 

 

UNIX

 

SCOsource

 

Total

 

 

 

 

 

 

 

 

 

Revenue

 

$

18,023

 

$

100

 

$

18,123

 

Cost of revenue

 

2,702

 

6,382

 

9,084

 

Gross margin (deficit)

 

15,321

 

(6,282

)

9,039

 

Sales and marketing

 

5,760

 

154

 

5,914

 

Research and development

 

4,003

 

202

 

4,205

 

General and administrative

 

3,538

 

261

 

3,799

 

Amortization of intangibles

 

1,186

 

 

1,186

 

Total operating expenses

 

14,487

 

617

 

15,104

 

Income (loss) from operations

 

$

834

 

$

(6,899

)

$

(6,065

)

 

Intangible assets, which consist of the Company’s reseller channel, trade name and technology, have been assigned to the Company’s UNIX and SCOsource segments and consist of the following as of April 30, 2006 and October 31, 2005 (in thousands):

 

 

April 30,
2006

 

October 31,
2005

 

Intangible assets:

 

 

 

 

 

UNIX (reseller channel and trade name)

 

$

1,185

 

$

2,370

 

SCOsource (UNIX technology)

 

168

 

337

 

Total intangible assets

 

$

1,353

 

$

2,707

 

 

17



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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations and other parts of this quarterly report on Form 10-Q contain forward-looking statements that involve risks and uncertainties.  Forward-looking statements can also be identified by words such as “intends,” “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms.  Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements.  Factors that might cause such differences include, but are not limited to, those set forth below under “Forward-Looking Statements and Factors that May Affect Future Results and Financial Condition” and Item 1A — Risk Factors and elsewhere in this Form 10-Q. The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included in this Form 10-Q and our audited consolidated financial statements included in our annual report on Form 10-K for the year ended October 31, 2005 filed with the Securities and Exchange Commission and management’s discussion and analysis contained therein.  All information presented herein is based on the three and six months ended April 30, 2006.  We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

 

Overview

Historical Background.  We originally incorporated as Caldera Systems, Inc., a Utah corporation (“Caldera Systems”), on August 21, 1998, and reincorporated as a Delaware corporation on March 6, 2000.  In March 2000, we completed an initial public offering of our common stock.  On May 7, 2001, we formed a new holding company in Delaware under the name of Caldera International, Inc. (“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.

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 operating systems and software products to power computers running on Intel architecture.  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 operations in a number of countries that provide support and services to customers and resellers.  The other principal channel for selling and marketing our UNIX products is through existing customers that have a large number of replicated sites or franchisees.

We access these corporations through their information technology or purchasing departments with our area sales managers 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 fiscal 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.

18



The following table shows the operating results of the UNIX business for the three and six months ended April 30, 2006 and 2005 (in thousands):

 

 

Three Months Ended April 30,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Revenue

 

$

7,092

 

$

9,228

 

Cost of revenue

 

1,206

 

1,309

 

Gross margin

 

5,886

 

7,919

 

Sales and marketing

 

2,856

 

2,963

 

Research and development

 

1,792

 

2,027

 

General and administrative

 

1,681

 

1,866

 

Amortization of intangibles

 

593

 

593

 

Total operating expenses

 

6,922

 

7,449

 

Income (loss) from operations

 

$

(1,036

)

$

470

 

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Revenue

 

$

14,405

 

$

18,023

 

Cost of revenue

 

2,427

 

2,702

 

Gross margin

 

11,978

 

15,321

 

Sales and marketing

 

5,544

 

5,760

 

Research and development

 

3,569

 

4,003

 

General and administrative

 

3,213

 

3,538

 

Amortization of intangibles

 

1,185

 

1,186

 

Total operating expenses

 

13,511

 

14,487

 

Income (loss) from operations

 

$

(1,533

)

$

834

 

 

Revenue from our UNIX business decreased by $2,136,000, or 23%, for the three months ended April 30, 2006 compared to the three months ended April 30, 2005 and decreased by $3,618,000, or 20%, for the six months ended April 30, 2006 compared to the six months ended April 30, 2005.  The revenue from this business has been declining over the last several periods primarily as a result of increased competition from alternative operating systems, particularly Linux.  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 try to achieve and sustain profitability and generate positive cash flow from our UNIX business, we have decreased our operating costs.  Operating costs for our UNIX business decreased from $7,449,000 for the three months ended April 30, 2005 to $6,922,000 for the three months ended April 30, 2006 and decreased from $14,487,000 for the six months ended April 30, 2005 to $13,511,000 for the six months ended April 30, 2006.  These cost reductions have primarily been attributable to operational efficiencies generated in our UNIX business as well as from the consolidation of certain facilities, offset by an increase in stock-based compensation as a result of the adoption of SFAS No. 123(R) for the three and six months ended April 30, 2006.

19



 

In our UNIX business, we have reduced the number of full-time equivalent employees from 164 as of April 30, 2005 to 162 as of April 30, 2006.  We have taken these headcount reductions and reduced other discretionary spending while still maintaining a worldwide presence.

The decline in our UNIX business revenue may be accelerated if industry partners withdraw their support for our products.  The decline in our UNIX business and our SCOsource business may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products.  This would lead to an accelerated decline in revenue and, potentially, negative cash flow 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 and defend our UNIX intellectual property, we initiated our SCOsource business.  Our SCOsource revenue for the years ended October 31, 2005 and 2004 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 with us until an outcome in this legal matter has been reached.

The following table shows the operating results of the SCOsource business for the three and six months ended April 30, 2006 and 2005 (in thousands):

 

 

Three Months Ended April 30,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Revenue

 

$

34

 

$

30

 

Cost of revenue

 

3,762

 

2,889

 

Gross deficit

 

(3,728

)

(2,859

)

Sales and marketing

 

1

 

7

 

Research and development

 

94

 

90

 

General and administrative

 

37

 

170

 

Total operating expenses

 

132

 

267

 

Loss from operations

 

$

(3,860

)

$

(3,126

)

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Revenue

 

$

64

 

$

100

 

Cost of revenue

 

7,772

 

6,382

 

Gross deficit

 

(7,708

)

(6,282

)

Sales and marketing

 

1

 

154

 

Research and development

 

188

 

202

 

General and administrative

 

97

 

261

 

Total operating expenses

 

286

 

617

 

Loss from operations

 

$

(7,994

)

$

(6,899

)

 

20



 

Revenue from our SCOsource business increased slightly from $30,000 for the three months ended April 30, 2005 to $34,000 for the three months ended April 30, 2006 and decreased from $100,000 for the six months ended April 30, 2005 to $64,000 for the six months ended April 30, 2006.  Revenue in the above mentioned periods was primarily attributable to sales of our SCOsource IP agreements.

Cost of revenue, which primarily includes legal and professional fees incurred in connection with the SCO Litigation, increased from $2,889,000 for the three months ended April 30, 2005 to $3,762,000 for the three months ended April 30, 2006 and increased from $6,382,000 for the six months ended April 30, 2005 to $7,772,000 for the six months ended April 30, 2006.  These increases were primarily attributable to significant work performed by technical, damage and industry experts and other consultants in connection with the SCO Litigation.  Because of the unique and unpredictable nature of the SCO Litigation, the occurrence and timing of certain expenses such as damage, industry and technical review and other consultants is difficult to predict, and it will be difficult to predict the total cost of revenue for the upcoming quarters.

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 Policies

Our critical accounting policies and estimates include the following:

                              Revenue recognition;

                              Deferred income tax assets and related valuation allowances;

                              Litigation reserves;

                              Impairment and useful lives of long-lived assets; and

                              Allowances for doubtful accounts receivable.

Revenue Recognition.  We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, as modified by SOP 98-9.  Our revenue has historically been from three sources: (i) product license revenue, primarily from product sales to resellers, end users and OEMs; (ii) technical support service revenue, primarily from providing technical support and consulting services to end users; and (iii) revenue from SCOsource licensing.

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

The majority of our revenue transactions relate to product-only sales.  On occasion, we have revenue transactions that have multiple elements (such as software 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 the relative fair value of the elements.  The fair value of each element is based on vendor specific objective evidence (“VSOE”).  VSOE is established when such elements are sold separately.  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

 

21



 

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

We consider an arrangement with payment terms longer than our normal business practice, not to be fixed or determinable and revenue is recognized when the fee becomes due.  We typically provide stock rotation rights for sales made through our distribution channel and sales to distributors are recognized upon shipment by the distributor to end users.  For direct sales not through our distribution channel, sales are typically non-refundable and non-cancelable.  We estimate our product returns based on historical experience and maintain an allowance for estimated returns, which is recorded as a reduction to accounts receivable.

Our SCOsource revenue to date has been primarily generated from agreements to utilize our UNIX source code as well as from intellectual property compliance agreements.  We recognize revenue from SCOsource agreements when a signed contract exists, the fee is fixed or determinable, collection of the receivable is probable and delivery has occurred.  If the payment terms extend beyond our normal payment terms, revenue is recognized as the payments become due.

Deferred Income Tax Assets 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 income tax assets 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.

Litigation Reserves.  We are party to a number of legal matters described in more detail elsewhere in this quarterly report on Form 10-Q.  Pursuit and defense of these matters will be costly, and management expects the costs for legal fees and related expenses will be substantial.  The ultimate outcome or potential negative effect on our results of operations or financial position of the Red Hat, Inc., IPO Class Action, Indian Distributor matters, or the IBM and Novell counterclaims is neither probable nor estimable.  Because these matters are not probable or estimable, we have not recorded any reserves or contingencies related to these legal matters.  In the event that our assumptions used to evaluate these matters as neither probable nor estimable changes in future periods, we may be required to record a liability for an adverse outcome, which could have a material adverse effect on our results of operations and financial position.

Impairment and Useful Lives of Long-lived Assets.  We review our long-lived tangible and intangible 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.  Economic useful lives of long-lived assets are assessed and adjusted as circumstances dictate.

 

22



 

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 Receivable.  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 apply these policies consistently.  Our allowance for doubtful accounts receivable, which is determined based on our historical experience and a specific review of customer balances, was $119,000 as of April 30, 2006.  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 three and six months ended April 30, 2006 and 2005 (in thousands):

 

 

Three Months Ended April 30,

 

Six Months Ended April 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Statement of Operations Data:

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

 

Products

 

$

5,703

 

$

7,838

 

$

11,703

 

$

15,142

 

SCOsource licensing

 

34

 

30

 

64

 

100

 

Services

 

1,389

 

1,390

 

2,702

 

2,881

 

Total revenue

 

7,126

 

9,258

 

14,469

 

18,123

 

Cost of revenue:

 

 

 

 

 

 

 

 

 

Products

 

497

 

563

 

1,081

 

1,207

 

SCOsource licensing

 

3,762

 

2,889

 

7,772

 

6,382

 

Services

 

709

 

746

 

1,346

 

1,495

 

Total cost of revenue

 

4,968

 

4,198

 

10,199

 

9,084

 

Gross margin

 

2,158

 

5,060

 

4,270

 

9,039

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing

 

2,857

 

2,970

 

5,545

 

5,914

 

Research and development

 

1,886

 

2,117

 

3,757

 

4,205

 

General and administrative

 

1,718

 

2,036

 

3,310

 

3,799

 

Amortization of intangibles

 

593

 

593

 

1,185

 

1,186

 

Total operating expenses

 

7,054

 

7,716

 

13,797

 

15,104

 

Loss from operations

 

(4,896

)

(2,656

)

(9,527

)

(6,065

)

Equity in income (loss) of affiliate

 

 

17

 

(8

)

70

 

Other income, net

 

316

 

800

 

461

 

1,309

 

Provision for income taxes

 

(114

)

(123

)

(201

)

(237

)

Net loss

 

$

(4,694

)

$

(1,962

)

$

(9,275

)

$

(4,923

)

 

THREE AND SIX MONTHS ENDED APRIL 30, 2006 AND 2005

Revenue

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Revenue

 

$

7,126,000

 

(23

)%

$

9,258,000

 

 

23



 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Revenue

 

$

14,469,000

 

(20

)%

$

18,123,000

 

 

Revenue for the three months ended April 30, 2006 decreased by $2,132,000, or 23%, from the three months ended April 30, 2005, and revenue for the six months ended April 30, 2006 decreased by $3,654,000, or 20%, from the six months ended April 30, 2005.  These decreases were primarily attributable to a continued decline in our UNIX business as a result of continued competitive pressure from competing operating systems, particularly Linux.

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

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

UNIX revenue

 

$

7,092,000

 

(23

)%

$

9,228,000

 

Percent of total revenue

 

100

%

 

 

100

%

SCOsource revenue

 

34,000

 

13

%

30,000

 

Percent of total revenue

 

0

%

 

 

0

%

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

UNIX revenue

 

$

14,405,000

 

(20

)%

$

18,023,000

 

Percent of total revenue

 

100

%

 

 

99

SCOsource revenue

 

64,000

 

(36

)%

100,000

 

Percent of total revenue

 

0

%

 

 

1

%

 

The decrease in revenue in the UNIX business of $2,136,000, or 23%, for the three months ended April 30, 2006 compared to the three months ended April 30, 2005 and the decrease in revenue of $3,618,000, or 20%, for the six months ended April 30, 2006 compared to the six months ended April 30, 2005 was primarily attributable to continued competition from other operating systems, particularly Linux.  We anticipate that for the remainder of the year ending October 31, 2006 our UNIX business and the related revenue from the UNIX business will face significant competition from Linux and other operating systems.

Sales of our UNIX products and services during the three and six months ended April 30, 2006 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.

Products Revenue

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Products revenue

 

$

5,703,000

 

(27

)%

$

7,838,000

 

Percent of total revenue

 

80

%

 

 

85

%

 

24



 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Products revenue

 

$

11,703,000

 

(23

)%

$

15,142,000

 

Percent of total revenue

 

81

%

 

 

84

%

 

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

The decrease in products revenue of $2,135,000, or 27%, for the three months ended April 30, 2006 compared to the three months ended April 30, 2005 and the decrease in products revenue of $3,439,000, or 23%, for the six months ended April 30, 2006 compared to the six months ended April 30, 2005 were primarily attributable to decreased sales of OpenServer, UnixWare and other products primarily resulting from increased competition in the operating system market, particularly from Linux.

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

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

OpenServer revenue

 

$

3,370,000

 

(28

)%

$

4,664,000

 

Percent of products revenue

 

59

%

 

 

60

%

UnixWare revenue

 

1,584,000

 

(34

)%

2,391,000

 

Percent of products revenue

 

28

%

 

 

30

%

Other products revenue

 

749,000

 

(4

)%

783,000

 

Percent of products revenue

 

13

%

 

 

10

%

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

OpenServer revenue

 

$

6,991,000

 

(19

)%

$

8,677,000

 

Percent of products revenue

 

60

%

 

 

57

%

UnixWare revenue

 

3,309,000

 

(27

)%

4,527,000

 

Percent of products revenue

 

28

%

 

 

30

%

Other products revenue

 

1,403,000

 

(28

)%

1,938,000

 

Percent of products revenue

 

12

%

 

 

13

%

 

The decreases in revenue for OpenServer and UnixWare for the three and six months ended April 30, 2006 compared to the three and six months ended April 30, 2005 are primarily the result of continued competition from other operating systems, particularly Linux.  The decrease in other products revenue is primarily attributable to decreased sales of product maintenance due to fewer customers renewing or ordering product maintenance.

SCOsource Licensing Revenue

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

SCOsource licensing revenue

 

$

34,000

 

13

%

$

30,000

 

 

25



 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

SCOsource licensing revenue

 

$

64,000

 

(36

)%

$

100,000

 

 

We initiated our SCOsource business for the purpose of protecting and defending our intellectual property rights in our UNIX source code and derivative works.  SCOsource licensing revenue was $34,000 for the three months ended April 30, 2006 compared to $30,000 for the three months ended April 30, 2005 and SCOsource licensing revenue was $64,000 for the six months ended April 30, 2006 compared to $100,000 for the six months ended April 30, 2005.

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

Services Revenue

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Services revenue

 

$

1,389,000

 

0

%

$

1,390,000

 

Percent of total revenue

 

20

%

 

 

15

%

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Services revenue

 

$

2,702,000

 

(6

)%

$

2,881,000

 

Percent of total revenue

 

19

%

 

 

16

%

 

Services revenue consists primarily of technical support fees, engineering services fees, professional services fees and consulting fees.  These fees are typically charged and invoiced separately from UNIX products sales.  Services revenue was flat for the three months ended April 30, 2006 as compared to the three months ended April 30, 2005.  The decrease in services revenue of $179,000, or 6%, for the six months ended April 30, 2006 as compared to the six months ended April 30, 2005 was primarily attributable to a decrease in the dollar amount of support and engineering services fees as well as to the decrease in products 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

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Cost of products revenue

 

$

497,000

 

(12

)%

$

563,000

 

Percent of products revenue

 

9

%

 

 

7

%

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Cost of products revenue

 

$

1,081,000

 

(10

)%

$

1,207,000

 

Percent of products revenue

 

9

%

 

 

8

%

 

26



 

Cost of products revenue consists of manufacturing costs, royalties to third-party vendors, technology costs and overhead costs.  Cost of products revenue decreased by $66,000, or 12%, for the three months ended April 30, 2006 as compared to the three months ended April 30, 2005 and cost of products revenue decreased by $126,000, or 10%, for the six months ended April 30, 2006 as compared to the six months ended April 30, 2005.  The decrease in the dollar amount of cost of products revenue was primarily attributable to lower products revenue as margins did not vary considerably.

For the remaining quarters of the year ending October 31, 2006, we expect the dollar amount of our cost of products revenue to be generally consistent with the cost of products revenue incurred during the three months ended April 30, 2006 and that cost of products revenue as a percent of products revenue for the remaining quarters of the year ending October 31, 2006 will be generally consistent with that incurred during the three months ended April 30, 2006.

Cost of SCOsource Licensing Revenue 

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Cost of SCOsource licensing revenue

 

$

3,762,000

 

30

%

$

2,889,000

 

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Cost of SCOsource licensing revenue

 

$

7,772,000

 

22

%

$

6,382,000

 

 

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 increased by $873,000, or 30%, during the three months ended April 30, 2006 as compared to the three months ended April 30, 2005 and increased by $1,390,000, or 22%, during the six months ended April 30, 2006 as compared to the six months ended April 30, 2005.  The increase in costs for the three and six months ended April 30, 2006 compared to the three and six months ended April 30, 2005 was primarily attributable to increased costs for expert, technical and industry, and damage consultants incurred in connection with our SCO Litigation.

Because of the unique and unpredictable nature of the SCO Litigation, the occurrence and timing of certain expenses is difficult to predict, and will be difficult to predict for the upcoming quarters.  We will continue to make payments for technical, damage and industry experts, consultants and for 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 the cost of SCOsource licensing revenue for the remaining quarters of the year ending October 31, 2006 to be higher than the costs incurred for the three months ended April 30, 2006.

Cost of Services Revenue

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Cost of services revenue

 

$

709,000

 

(5

)%

$

746,000

 

Percent of services revenue

 

51

%

 

 

54

%

 

27



 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Cost of services revenue

 

$

1,346,000

 

(10

)%

$

1,495,000

 

Percent of services revenue

 

50

%

 

 

52

%

 

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 $37,000, or 5%, for the three months ended April 30, 2006 compared to the three months ended April 30, 2005 and decreased by $149,000, or 10%, for the six months ended April 30, 2006 as compared to the six months ended April 30, 2005.  This decrease was primarily attributable to reduced numbers of employees and related costs.

For the remaining quarters of the year ending October 31, 2006, we expect the dollar amount of our cost of services revenue to be generally consistent with the cost of services revenue incurred during the three months ended April 30, 2006 and that cost of services revenue as a percent of services revenue for the remaining quarters of the year ending October 31, 2006 will be generally consistent with that incurred during the three months ended April 30, 2006.

Sales and Marketing

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Sales and marketing expenses

 

$

2,857,000

 

(4

)%

$

2,970,000

 

Percent of total revenue

 

40

%

 

 

32

%

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Sales and marketing expenses

 

$

5,545,000

 

(6

)%

$

5,914,000

 

Percent of total revenue

 

38

%

 

 

33

%

 

Sales and marketing expenses consist of the salaries, commissions and other personnel costs of employees involved in the revenue generation process, as well as advertising and corporate allocations.  The decrease in sales and marketing expenses of $113,000, or 4%, for the three months ended April 30, 2006 compared with the three months ended April 30, 2005 and the decrease of $369,000, or 6%, for the six months ended April 30, 2006 compared with the six months ended April 30, 2005 was primarily attributable to decreased spending on co-operative advertising and decreased discretionary spending.  Included in sales and marketing expenses for the three months ended April 30, 2006 and 2005 was $91,000 and $7,000, respectively, for stock-based compensation.  Included in sales and marketing expenses for the six months ended April 30, 2006 and 2005 was $159,000 and $14,000, respectively, for stock-based compensation.  Our sales and marketing full-time equivalent employees increased from 52 as of April 30, 2005 to 54 as of April 30, 2006.

For the remaining quarters of the year ending October 31, 2006, we anticipate that the dollar amount of sales and marketing expenses will be generally consistent with that incurred during the three months ended April 30, 2006.

Research and Development

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Research and development expenses

 

$

1,886,000

 

(11

)%

$

2,117,000

 

Percent of total revenue

 

26

%

 

 

23

%

 

28



 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Research and development expenses

 

$3,757,000

 

(11

)%

$4,205,000

 

Percent of total revenue

 

26

%

 

 

23

%

 

Research and development expenses consist of the salaries and benefits of software engineers, consulting expenses and corporate allocations.  Research and development expenses decreased by $231,000, or 11%, for the three months ended April 30, 2006 compared with the three months ended April 30, 2005 and decreased by $448,000, or 11%, for the six months ended April 30, 2006 compared with the six months ended April 30, 2005, which was primarily attributable to decreased personnel and personnel-related costs.  Included in research and development expenses for the three months ended April 30, 2006 and 2005 was $36,000 and $0, respectively, of stock-based compensation.  Included in research and development expenses for the six months ended April 30, 2006 and 2005 was $56,000 and $8,000, respectively, of stock-based compensation.  Our research and development full-time equivalent employees decreased from 52 as of April 30, 2005 to 49 as of April 30, 2006.

For the remaining quarters of the year ending October 31, 2006, we anticipate that the dollar amount of research and development expenses will be generally consistent with that incurred during the three months ended April 30, 2006.

General and Administrative

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

General and administrative expenses

 

$

1,718,000

 

(16

)%

$

2,036,000

 

Percent of total revenue

 

24

%

 

 

22

%

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

General and administrative expenses

 

$

3,310,000

 

(13

)%

$

3,799,000

 

Percent of total revenue

 

23

%

 

 

21

%

 

General and administrative expenses consist of the salaries and benefits of finance, human resources, and executive management and expenses for professional services and corporate allocations.  General and administrative expenses decreased by $318,000, or 16%, during the three months ended April 30, 2006 as compared to the three months ended April 30, 2005 and decreased by $489,000, or 13%, during the six months ended April 30, 2006 as compared to the six months ended April 30, 2005.  The decrease in general and administrative expenses was primarily attributable to decreased professional service fees attributed to accounting, auditing and legal work, offset, in part, by stock-based compensation.  Included in general and administrative expenses for the three months ended April 30, 2006 and 2005 was $227,000 and $0, respectively, of stock-based compensation.  Included in general and administrative expenses for the six months ended April 30, 2006 and 2005 was $472,000 and $0, respectively, of stock-based compensation.  Our general and administrative full-time equivalent employees decreased from 29 as of April 30, 2005 to 28 as of April 30, 2006.

For the remaining quarters of the year ending October 31, 2006, we anticipate that the dollar amount of general and administrative expenses will be generally consistent to that incurred during the three months ended April 30, 2006.

 

29



 

Amortization of Intangibles

 

 

Three Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Amortization of intangibles

 

$

593,000

 

0

%

$

593,000

 

Percent of total revenue

 

8

%

 

 

6

%

 

 

 

Six Months Ended April 30,

 

 

 

2006

 

Change

 

2005

 

 

 

 

 

 

 

 

 

Amortization of intangibles

 

$

1,185,000

 

0

%