10-K 1 a05-6064_110k.htm 10-K

 

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, 2004

 

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
offices, including zip code)

 

(Registrant’s telephone
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 $.001 per share

 

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 o  NO ý

 

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 an accelerated filer (as defined in Rule 12b-2 of the Act).  YES o  NO ý

 

The aggregate market value of the common stock held by non-affiliates of the Registrant already made $33,021,000 based on the reported last sale price of common stock on April 30, 2004, 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 March 30, 2005, was 17,915,292.

 

 



 

 

 

 

 

PART I.

 

 

 

Item 1.

 

Business

 

Item 2.

 

Properties

 

Item 3.

 

Legal Proceedings

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

 

 

 

 

PART II.

 

 

 

Item 5.

 

Market for the 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

 

Item 13.

 

Certain Relationships and Related Transactions

 

Item 14.

 

Principal Accounting Fees and Services

 

 

 

 

 

PART IV.

 

 

 

Item 15.

 

Exhibits, 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”) contains 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 II, Item 7 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.  We generate revenue from sales of our UNIX-based products and services through our UNIX business and from sales of SCOsource intellectual property (“IP”) licenses and vendor licenses of our UNIX technology through our SCOsource business.  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.  During fiscal year 2004, we released a new version of our UnixWare product and we intend to continue to maintain our core UNIX business in fiscal year 2005 by continuing our research and development efforts.  We plan to release the next major upgrade to our OpenServer product during the first half of calendar year 2005.

 

We developed our SCOsource initiatives 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 in 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 connection with our SCOsource initiatives, 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 action against these parties and the procedural status of these cases in more detail below under Part I, Item 3 of this Form 10-K.

 

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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 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, now known as Tarantella, Inc.  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, including branch offices and franchisees of Fortune 1000 companies, by providing reliable, cost-effective UNIX operating systems and software products to power computers based on the Intel architecture.  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 a presence in a number of countries that provides 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 initiatives, described in more detail below in the subsection entitled “SCOsource Initiatives” under the section entitled “SCOsource Business.”

 

UNIX has had a long history of small 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 business.  Our UNIX product offerings permit businesses, particularly small businesses, 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.

 

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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 and constitute a well-known brand with a reputation for quality and reliability.  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.

 

In fiscal year 2005, we intend to focus our development resources on releasing our next OpenServer product and maintaining our recently updated UnixWare product.  We anticipate that the benefits of our next OpenServer product will be increased system reliability and performance, backward compatibility with existing applications and software, increased application support, increased hardware support and integration with widely used internet applications.  We also plan to focus development resources on augmenting our current UNIX products and our application products with other products that will solve business problems for our existing installed base of customers.  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, Novell, Hewlett-Packard, 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, networking capability and breadth of hardware compatibility.  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 hampered our ability to compete favorably to some degree.

 

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 in fiscal year 2004, and we believe that it will continue in fiscal year 2005.  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 SCOsource initiatives.

 

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 5.0.7, began shipping in February 2003.  We anticipate releasing the next version of OpenServer in the first half of calendar year 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.

 

SCO Applications.  We have released two application products: SCO Office Server and SCO Web Services Substrate (“WSS”).  These products run in conjunction with our UNIX operating systems.  SCO Office Server provides smaller companies the ability to send and receive e-mail messages, set calendar appointments, and perform other collaboration tasks using standard client software.  SCO WSS enables business users to modernize their legacy applications, making them function with modern systems that more readily share data for improved efficiency.  These application products represent increased capability and functionality for our UNIX customers.

 

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 in fiscal year 2005 will be critical to the success of our UNIX business, and in particular, to the success of our next OpenServer product.  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 SCOsource initiatives.

 

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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 56 percent of the total UNIX revenue for fiscal year 2004.  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 application are then deployed in an identical fashion across thousands of branch offices or franchisees.

 

International.  The International region delivered approximately 44 percent of our UNIX revenue for fiscal year 2004 and includes EMEA (Europe, the Middle East and Africa) and Asia Pacific.  We have a presence in many major countries, including 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 critical key to our future success will depend in part on 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:

 

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                  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.

 

Information regarding financial data by geographic regions and long-lived assets is set forth in Part II, Item 8 of this Form 10-K in the notes to 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 life 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.  However, we do believe that these improvements will extend the life of our current UNIX products.

 

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 amount 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.

 

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.

 

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 (now known as Tarantella, Inc.) had previously acquired such UNIX source code and other intellectual property rights from Novell in September 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

 

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proprietary rights, we rely primarily on a combination of copyright laws, contractual rights and a detailed legal strategy.

 

In fiscal year 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 copyrights related to our UNIX source code.  A related lawsuit was filed against us by Red Hat, Inc. (“Red Hat”). We describe our legal actions in more detail below under Part I, Item 3 of this Form 10-K.

 

SCOsource Initiatives

 

Reviewing and Evaluating Existing UNIX Licenses.  As mentioned above, in fiscal year 2003 we began reviewing the status of our existing UNIX license agreements with UNIX vendors and entered into two significant vendor license agreements.  This review continued in fiscal year 2004 and will continue in fiscal year 2005.

 

SCOsource IP License.  In August 2003, we first offered to Linux and other end users a license to use our UNIX intellectual property.  The SCOsource 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.  We will continue to pursue our SCOsource IP licensing initiative in fiscal year 2005.

 

Intellectual Property Protection

 

Our SCOsource initiatives rely 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 SCOsource initiatives 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 legal 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.

 

Current Status and Strategy

 

In fiscal year 2004, we continued to pursue our SCOsource initiatives.  The revenue generated from our SCOsource initiatives in fiscal year 2004 was significantly less than revenue generated in fiscal year 2003.  Fiscal year 2004 SCOsource revenue was primarily generated from SCOsource IP licenses.  For fiscal year 2005, we plan to continue to review and evaluate our UNIX license agreements and pursue large vendor contracts, such as those completed in fiscal year 2003, and plan to further pursue our SCOsource initiatives.

 

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We also plan to continue to pursue our litigation against IBM, Novell, AutoZone, and DaimlerChrysler and defend against the claims asserted by Red Hat.

 

Employees

 

As of October 31, 2004, we had a total of 200 full-time equivalent employees.  Of the total employees, 64 were in product development, 46 in sales, 16 in marketing, 21 in customer service and technical support, 10 in customer delivery, 7 in SCOsource and 36 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 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 fiscal year 2008.

 

Our international field operations occupy leased facilities in France, Japan, Germany, India, and the United Kingdom among others.  The leases for these field operation facilities expire at various dates through fiscal year 2010.

 

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 complaint against IBM.  This action is pending in the United States District Court for the District of Utah, under the title The SCO Group, Inc. v. International Business Machines Corporation, Civil No. 2:03CV0294.  The initial complaint included claims for breach of contract, misappropriation of trade secrets, tortious interference, and unfair competition.  The initial complaint also alleged that IBM had used and distributed information concerning the UNIX source code and derivative works in connection with its efforts to promote the Linux operating system.  As a result of IBM’s actions, we are requesting damages in an amount to be proven at trial, together with additional damages through and after the time of trial.  On or about June 13, 2003, we delivered to IBM a notice of termination of IBM’s UNIX license agreement, which underlies IBM’s AIX software.

 

On or about June 16, 2003, we filed an amended complaint in the IBM case.  The amended complaint essentially restated and re-alleged the allegations of the initial complaint and expanded on those claims.  Among other things, the amended complaint raised new allegations regarding IBM’s breaches (in ways similar to those set forth above) of a UNIX license agreement involving Sequent Computer Systems, Inc. (“Sequent”), which IBM had acquired.  We have sought damages for breaches of the Sequent license agreement.  We are also seeking injunctive relief on several claims.

 

IBM has filed a response and counterclaims to our complaint, including a demand for a jury trial.  We have filed an answer to the IBM counterclaims denying the claims and asserting affirmative defenses.  On February 4, 2004, we filed a motion for leave to file amended pleadings in the case proposing to amend our complaint against IBM and to modify our affirmative defenses to IBM’s counterclaims.  On February 25, 2004, the court granted our motion for leave to amend.

 

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Our second amended complaint, which was filed on February 27, 2004, alleges nine causes of action that are similar to those set forth above, adds a new claim for copyright infringement and removes the claim for misappropriation of trade secrets.  IBM 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 March 3, 2004, the U.S. Magistrate Judge issued an order addressing certain discovery matters relating to both us and IBM.

 

We thereafter filed motions to amend the scheduling order and to bifurcate IBM’s patent counterclaims into a separate action.  A hearing on those latter two motions was held on June 8, 2004.  The court issued its ruling on June 10, 2004, granting our motion to amend the scheduling order, with certain changes.  The court also denied the motion to bifurcate the patent counterclaims without prejudice to our right to request bifurcation again at a later date.

 

Following a hearing on October 19, 2004, on January 19, 2005, the Magistrate Judge issued a further order granting in part and denying in part discovery applications that we had made.  In that order, the court ordered IBM to produce much of the information, including source code and revision information, we had previously requested.  The court also struck the Amended Scheduling Order and directed the parties to submit a proposed amended scheduling order which both parties have done.

 

On February 9, 2005, the U.S. District Judge ruled on several pending dispositive motions.  The Court denied the 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, except by stipulation of the parties, and vacated its prior order, dated September 30, 2004, to the extent that order had granted permission to file dispositive motions before the close of discovery.

 

In addition to the materials that have been publicly filed with the court, certain information has been filed under seal in accordance with the protective order entered in the case.  On November 30, 2004, a third party filed a motion to intervene in the case for the purpose of challenging the sealing of certain documents with the court.  Additional groups have joined in that motion.  That motion has been scheduled for a hearing on April 26, 2005.

 

We have also filed a motion for leave to file a third amended complaint to allege an additional copyright violation against IBM in the case.  We expect that matter to be heard by the court in the next few months.  Discovery is continuing in the case.

 

Red Hat, Inc.

 

On August 4, 2003, Red Hat 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 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 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.

 

12



 

On or about September 15, 2003, we filed a motion to dismiss the Red Hat complaint.  The motion to dismiss asserted that Red Hat lacks standing and that no case or controversy exists with respect to the claims seeking a declaratory judgment of non-infringement.  The motion to dismiss further asserted that Red Hat’s claims under the Lanham Act and related state laws are barred by the First Amendment to the U.S. Constitution and the common law privilege of judicial immunity.  On April 6, 2004, the court issued an order denying our motion to dismiss; however, the court stayed the case and requested status reports every 90 days regarding the case against IBM.  Red Hat has filed a motion for reconsideration.  No ruling has been issued on that motion.  We intend to vigorously defend this action.

 

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.  The case, after removal to federal court, is pending in the United States District Court for the District of Utah, under the caption The SCO Group, Inc. v. Novell, Inc., Civil No. 2:04CV00139.  In the lawsuit, 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.

 

Novell removed the case to federal court and also filed a motion to dismiss our complaint claiming that it had never transferred the copyrights to The Santa Cruz Operation (now Tarantella, Inc.).  We filed a response to Novell’s motion to dismiss and have also filed a motion to remand the case back to the state court.  On June 10, 2004, the court issued a memorandum decision and order which denied our motion to remand the case to state court.  The memorandum decision also denied in part and granted in part Novell’s motion to dismiss.  The court granted Novell’s motion to dismiss regarding our allegations of special damages, but granted us thirty-days leave to amend our complaint to plead special damages with greater specificity.  We have filed our amended complaint and Novell has responded with another motion to dismiss claiming, among other things, that Novell’s false statements were not made with malice and are privileged under the law.  That motion has been briefed by the parties and is scheduled to be argued to the court on May 25, 2005.  We plan to continue to vigorously pursue our claims against Novell.

 

DaimlerChrysler Corporation

 

On or about March 3, 2004, we brought suit against DaimlerChrysler Corporation for its alleged violations of its UNIX license agreement.  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.

 

On April 15, 2004, DaimlerChrysler filed a motion to dismiss our claims.  DaimlerChrysler’s motion was heard on July 21, 2004, and 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.  Based on a stipulation of the parties, however, the court signed an order of dismissal without prejudice.  The appellate court has dismissed our appeal of the

 

13



 

July 21, 2004 ruling finding that the order was not a final, appealable order; we are evaluating our options regarding the appellate court’s ruling.

 

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.  Our 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.  On April 23, 2004, AutoZone filed a motion to transfer the case to Tennessee or to stay the case.  On August 6, 2004, the federal court in Nevada entered an order granting AutoZone’s motion to stay the case with 90-day status reports to the court.  The court denied without prejudice AutoZone’s motion for a more definite statement and its motion to transfer the case to Tennessee.  The court is allowing the parties to take limited expedited discovery relating to the issue of preliminary injunctive relief.  We are pursuing that discovery and continuing to evaluate our claims in that regard.

 

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 our directors and us.

 

We have notified our underwriters and insurance companies of the existence of the claims.  We believe, 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 amount already paid or accrued by us.

 

Other Matters

 

In April 2003, a former Indian distributor of ours 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.  The distributor additionally requested that the Indian courts grant interim relief in the form of attachment of local assets.  We do not believe that we are responsible to reimburse the distributor for any operating costs and also believe that the return rights related to any remaining inventory have lapsed.  Discovery has commenced and hearings on the requests for interim relief have been held and are ongoing.  We intend to vigorously defend this action.

 

We are a party to certain other legal proceedings arising in the ordinary course of business including legal proceedings arising from our SCOsource initiatives.  We believe, 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 or financial position.

 

14



 

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

 

There were no matters submitted to a vote of security holders during the fourth quarter of fiscal year 2004.

 

PART II

 

Item 5.  Market for the 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 SmallCap Market since February 2003.  In September 2002, we changed our trading symbol from “CALD” to “SCOX.”  As of February 18, 2005, the trading symbol for the common stock was changed from “SCOX” to “SCOXE” as a result of our failure to make a timely filing of this Form 10-K.  The table below sets forth the range of high and low closing prices of our common stock as reported on The Nasdaq National Market and The Nasdaq SmallCap Market, as applicable, for the last two years.

 

 

 

SCO Common Stock

 

 

 

High

 

Low

 

Fiscal Year 2004

 

 

 

 

 

Quarter ended January 31, 2004

 

$

19.08

 

$

13.65

 

Quarter ended April 30, 2004

 

14.40

 

6.27

 

Quarter ended July 31, 2004

 

6.34

 

4.03

 

Quarter ended October 31, 2004

 

5.10

 

2.98

 

 

 

 

 

 

 

Fiscal Year 2003

 

 

 

 

 

Quarter ended January 31, 2003

 

$

1.70

 

$

1.22

 

Quarter ended April 30, 2003

 

3.27

 

1.09

 

Quarter ended July 31, 2003

 

14.84

 

3.21

 

Quarter ended October 31, 2003

 

20.50

 

9.29

 

 

 

On March 29, 2005, the closing sales price for our common stock as reported by The Nasdaq SmallCap Market was $3.52.  As of March 28, 2005, there were 340 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.

 

Equity Compensation Plans

 

We maintain our 1998 Stock Option Plan, our 1999 Omnibus Stock Incentive Plan, our 2002 Omnibus Stock Incentive Plan, our 2004 Omnibus Stock Incentive Plan and our 2000 Employee Stock Purchase Plan (the “ESPP”).  We are no longer granting awards under the 1998 Stock Option Plan, which was superseded by the 1999 Omnibus Stock Incentive Plan.

 

15



 

The following table provides information about equity awards under our equity compensation plans as of October 31, 2004:

 

 

Plan Category

 

Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights

 

Weighted-average
exercise price of
outstanding
options, warrants
and rights

 

Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in the
first column)

 

 

 

 

 

 

 

 

 

Equity compensation plans approved by security holders

 

3,421,000

 

$

4.05

 

2,077,000

(1) (2)

 


(1)          The 2004 Omnibus Incentive Plan incorporates an evergreen formula pursuant to which on each November 1, the aggregate number of shares reserved for issuance under the 2004 Plan will increase by a number of shares equal to three percent of the outstanding shares on the day preceding (October 31).  The ESPP incorporates an evergreen formula pursuant to which on January 1 of each year the aggregate number of shares reserved for issuance under the ESPP will increase by a number of shares equal to one percent of the outstanding shares on the day preceding (December 31).

 

(2)          Of these shares, 248,000 shares remain available for purchase under the ESPP.

 

Recent Sales of Unregistered Securities

 

We have issued shares and granted options under our 1998 Stock Option Plan, 1999 Omnibus Stock Option Plan, the ESPP, 2002 Omnibus Stock Incentive Plan, and 2004 Omnibus Stock Incentive Plan (collectively, the “Equity Compensation Plans”) without complying with registration or qualification requirements under federal securities laws and the securities laws of certain states.  As a result, certain plan participants have a right to rescind their purchases of shares under the Equity Compensation Plans or recover damages if they no longer own the shares or hold unexercised options, subject to applicable statutes of limitations.  Additionally, regulatory authorities may require us to pay fines or impose other sanctions on us.  Although we are evaluating the possible actions we may take in response to these securities law compliance issues, we may, subject to obtaining required regulatory approvals, make a rescission offer to certain plan participants that hold unexercised options (in California, Georgia and possibly other states) or shares acquired under the Equity Compensation Plans or that otherwise are entitled to recover damages from us in respect of such shares they have sold.

 

Issuer Purchases of Equity Securities

 

During the fourth quarter of fiscal year 2004, we did not purchase any of our equity securities.

 

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, 2004, 2003 and 2002 and the selected balance sheet data as of October 31, 2004 and 2003 are derived from, and are qualified by reference to, the audited consolidated financial statements and related notes in this Form 10-K.

 

16



 

The selected statement of operations data for the years ended October 31, 2001 and 2000 and the selected balance sheet data as of October 31, 2002, 2001 and 2000 are derived from audited consolidated financial statements not appearing in this Form 10-K.

 

 

 

Years Ended October 31,

 

 

 

2004

 

2003

 

2002

 

2001

 

2000

 

 

 

(In thousands, except per share data)

 

Statement of Operations Data:

 

 

 

 

 

 

 

 

 

 

 

Total revenue

 

$

42,809

 

$

79,254

 

$

64,241

 

$

40,441

 

$

4,274

 

Gross margin

 

15,711

 

59,332

 

45,925

 

25,518

 

253

 

Income (loss) from operations

 

(28,573

)

3,436

 

(24,176

)

(133,636

)

(31,999

)

Net income available (loss applicable) to common stockholders

 

(16,227

)

5,304

 

(24,877

)

(131,357

)

(39,176

)

Basic net income (loss) per common share

 

$

(1.07

)

$

0.43

 

$

(1.93

)

$

(10.92

)

$

(4.76

)

Diluted net income (loss) per common share

 

$

(1.07

)

$

0.34

 

$

(1.93

)

$

(10.92

)

$

(4.76

)

Weighted average basic common shares

 

15,155

 

12,261

 

12,893

 

12,024

 

8,231

 

Weighted averaged diluted common shares

 

15,155

 

15,679

 

12,893

 

12,024

 

8,231

 

 

 

 

As of October 31,

 

 

 

2004

 

2003

 

2002

 

2001

 

2000

 

 

 

(In thousands)

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

12,693

 

$

64,428

 

$

6,589

 

$

20,541

 

$

36,560

 

Working capital (deficit)

 

15,413

 

37,168

 

(6,332

)

14,401

 

88,680

 

Total assets

 

55,400

 

94,952

 

37,406

 

74,859

 

107,518

 

Long-term liabilities

 

343

 

508

 

1,625

 

5,925

 

 

Redeemable preferred stock

 

 

29,671

 

 

 

 

Common stock subject to rescission

 

528

 

 

 

 

 

Total stockholders’ equity

 

21,702

 

19,516

 

8,177

 

34,604

 

102,215

 

 

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” below.  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 presented herein is based on our fiscal year ended October 31, 2004.  We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

 

Overview

 

Historical Background.  We originally incorporated as Caldera Systems, Inc., a Utah corporation (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

 

17



 

and operations of the server and professional services groups of The Santa Cruz Operation (now known as Tarantella, Inc.).  In connection with this acquisition, Caldera Systems became a wholly-owned subsidiary of Caldera International.  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.  As described in the section entitled “Recent Sales of Unregistered Securities” above in Part II, Item 5 of this Form 10-K,  we issued shares and granted options under our Equity Compensation Plans without complying with registration or qualification requirements under federal securities laws and the securities laws of certain states.  As a result, certain plan participants have a right to rescind their purchases of shares under the Equity Compensation Plans or recover damages if they no longer own the shares or hold unexercised options, subject to applicable statutes of limitations.  Although we are evaluating the possible actions we may take in response to these securities law compliance issues, we may make a rescission offer to certain plan participants entitled to rescission rights subject to obtaining required regulatory approvals.  If our potential rescission offer is made and accepted by all plan participants holding certain ESPP shares and all shares acquired from the exercise of stock options, or such participants otherwise make rescission claims against us, we could be required to make aggregate payments to these plan participants of up to $528,000.  This amount is based on ESPP shares and shares issued upon the exercise of stock options that have been retained by plan participants as of October 31, 2004 and excludes interest and other charges we may be required to pay.  We may face additional rescission liability to plan participants holding unexercised stock options in California, Georgia and possibly other states, and regulatory authorities also may require us to pay fines or impose other sanctions on us.

 

On February 16, 2005, we received a notice from the staff of The Nasdaq Stock Market indicating that we are subject to potential delisting from The Nasdaq SmallCap Market for failure to comply with Nasdaq’s requirement to file this Form 10-K for the fiscal year ended October 31, 2004 in a timely fashion.  Receipt of the notice did not result in immediate delisting of our common stock.  Nasdaq stated that, unless we requested a hearing on Nasdaq’s delisting notice, our securities would be delisted from The Nasdaq SmallCap Market at the opening of business on February 25, 2005.

 

We requested a hearing with the Nasdaq Listing Qualifications Panel on this matter, which stayed the delisting pending the hearing and a determination by the Nasdaq Listing Qualifications Panel.  The hearing occurred on March 17, 2005.  At the hearing, we outlined for the Panel our plan for filing this Form 10-K and our Quarterly Report on Form 10-Q for the first quarter of the current fiscal year (the “Form 10-Q”), which also was not filed in a timely fashion.  On March 18, 2005, we received another notice from the staff of The Nasdaq Stock Market regarding our potential delisting as a result of our failure to file the Form 10-Q in a timely fashion.  The notice informed us that the Panel will consider the filing delinquency of our Form 10-Q in addition to the filing delinquency of this Form 10-K in rendering its decision regarding our listing status.  We will continue to be listed on The Nasdaq SmallCap Market under the symbol SCOXE pending the issuance of the Panel’s decision.

 

On October 31, 2004, we entered into an engagement agreement (the “Engagement Agreement”) with Boies, Schiller & Flexner LLP, Kevin McBride and Berger Singerman (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 our current litigation between us and IBM, Novell, Red Hat, AutoZone and DaimlerChrysler (the “SCO Litigation”), through the end of the current litigation between us and 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 certain previously accrued expenses totaling $13,906,000 at October 31,

 

18



 

2004 and all future attorney fees in connection with the SCO Litigation through the end of the current litigation between us and IBM and the escrow of at least $5,000,000 for the payment of any expert, consulting and other expenses.  As of October 31, 2004, this $5,000,000 was classified as a component of restricted cash.  We paid the $13,906,000 subsequent to October 31, 2004.

 

Future legal fees covered under the Engagement Agreement will require us to pay to the Law Firms $2,000,000 per quarter for each successive quarter beginning September 1, 2004 and ending December 1, 2005 for a total amount of $12,000,000, of which $10,000,000 will be paid in fiscal year 2005.  In the first quarter of fiscal year 2005, we made the quarterly payments for September 2004 as well as December 2004 for a total of $4,000,000.  The payment of these fees has had and will continue to have a material impact on our cash position.

 

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 recovery from our litigation, our intellectual property licensing 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:

 

                  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.

 

Business Focus

 

We generate revenue from sales of product and services from our UNIX business and from sales of SCOsource IP licenses and vendor licenses from our SCOsource business.

 

UNIX Business.  Our UNIX business serves the needs of small-to-medium sized businesses, including replicated site franchisees of Fortune 1000 companies, by providing reliable, cost effective UNIX 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 a presence in a number of countries that provide support and services to customers and resellers.  The other principal channel for selling and marketing our UNIX products is through existing customers that have a large number of replicated sites or franchisees.

 

We access these corporations through their information technology or purchasing departments with our 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 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.

 

19



 

The following table shows the operating results of the UNIX business for fiscal years 2004, 2003 and 2002 (in thousands):

 

 

 

2004

 

2003

 

2002

 

Revenue

 

$

41,980

 

$

53,408

 

$

64,241

 

Cost of revenue

 

7,355

 

10,422

 

18,316

 

Gross margin

 

34,625

 

42,986

 

45,925

 

Sales and marketing

 

15,806

 

24,392

 

29,554

 

Research and development

 

10,126

 

11,012

 

17,558

 

General and administrative

 

7,385

 

6,230

 

9,307

 

Other (1)

 

9,008

 

5,306

 

13,682

 

Total operating expenses

 

42,325

 

46,940

 

70,101

 

Loss from operations

 

$

(7,700

)

$

(3,954

)

$

(24,176

)

 


(1)          Other costs include amortization of intangibles, stock-based compensation, loss on disposition and write-offs of long-lived assets, loss on investments and severance and exit costs.

 

Revenue from our UNIX business decreased by $11,428,000, or 21 percent, for fiscal year 2004 compared to fiscal year 2003 and decreased by $10,833,000, or 17 percent, for fiscal year 2003 compared to fiscal year 2002.  The revenue from this business has been declining over the last several fiscal years primarily as a result of increased competition from alternative operating systems, particularly Linux.  If revenue from our UNIX business continues to decline and we are unable to generate positive cash flow, our UNIX business will be adversely impacted.

 

In an effort to try to reach profitability in our UNIX business, we have decreased our operating costs and increased our gross margin percentage in each of the last three fiscal years.  Operating costs for our UNIX business decreased from $70,101,000 for fiscal year 2002 to $46,940,000 for fiscal year 2003, and then further decreased to $42,325,000 for fiscal year 2004.  These cost reductions have primarily been attributable to reduced headcount and continued operational efficiencies generated in our UNIX business as well as from the consolidation of certain facilities.  During fiscal year 2004, we incurred a charge for severance and exit costs of $3,168,000 and incurred a loss on disposition and write-off of long lived assets of $2,355,000.  Both of these charges negatively impacted our loss from operations for fiscal year 2004.

 

In our UNIX business, we have reduced the number of full-time equivalent employees from 340 as of October 31, 2002, to 295 as of October 31, 2003 to 193 as of October 31, 2004.  We have taken these headcount reductions and reduced other discretionary spending while still maintaining a worldwide presence.  Based on our cost-cutting actions, we anticipate that our UNIX business will generate positive cash flow during fiscal year 2005.

 

The decline in our UNIX business revenue may be accelerated if industry partners withdraw their support as a result of our SCOsource initiatives.  The decline in our UNIX business and our SCOsource initiatives may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products.  This would lead to an accelerated decline in revenue from our UNIX business.

 

An important initiative for our UNIX business for the 2005 fiscal year will be the release of a new version of our OpenServer operating system in the first half of calendar year 2005.  This new version will provide increased system reliability, backward compatibility with existing applications and software, increased application and hardware support, integration with widely used internet applications and increased system performance.  These enhancements will not have a direct impact on our short-term OpenServer revenue because of the long adoption cycle for new operating system purchases and our long operating system product sales cycle, but we believe that they will help prolong our OpenServer revenue stream for future quarters.

 

SCOsource Business.  During the 2003 fiscal year, we became aware that our UNIX code and derivative works had been inappropriately included in the Linux operating system.  We believe the inclusion of our UNIX code and derivative works in Linux has been a major contributor to the decline in

 

20



 

our UNIX business because users of Linux generally do not pay for the operating system but pay only minimal fees, if any, for service and maintenance.  The Linux operating system competes directly with our 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.  These initiatives now include seeking to enter into license agreements with UNIX vendors and offering SCOsource IP licenses to Linux and other end users allowing them to continue to use our UNIX source code and derivative works found in Linux.  Our SCOsource efforts resulted in the execution of two significant vendor license agreements during fiscal year 2003, but we did not enter into any significant vendor license agreements in fiscal year 2004.  Our revenue for fiscal year 2004 was significantly lower than revenue generated in fiscal year 2003.  We believe and allege revenue and related revenue opportunities for fiscal year 2004 were adversely impacted by our outstanding dispute with Novell over our UNIX copyright ownership, which may have caused potential customers to delay or forego licensing until an outcome in this legal matter has been reached.

 

During fiscal year 2004, we began assigning direct resources to the SCOsource business for sales and marketing, research and development and general and administrative.  There were no direct costs associated with selling, marketing, research and development and general and administration for the 2003 fiscal year and our SCOsource business did not exist during fiscal year 2002.  The following table shows the results of operations for the SCOsource business (in thousands):

 

 

 

2004

 

2003

 

2002

 

 

 

 

 

 

 

 

 

Revenue

 

$

829

 

$

25,846

 

$

 

Cost of revenue

 

19,743

 

9,500

 

 

Gross margin (deficit)

 

(18,914

)

16,346

 

 

Sales and marketing

 

1,232

 

 

 

Research and development

 

486

 

 

 

General and administrative

 

241

 

 

 

Other

 

 

8,956

 

 

Total operating expenses

 

1,959

 

8,956

 

 

Income (loss) from operations

 

$

(20,873

)

$

7,390

 

$

 

 

 

Revenue from our SCOsource business decreased from $25,846,000 in fiscal year 2003 to $829,000 in fiscal year 2004.  During fiscal year 2003, the revenue generated was primarily attributable to two large vendor licenses, and we did not close any similar transactions during fiscal year 2004.  Revenue in fiscal year 2004 was primarily attributable to sales of our SCOsource IP licenses.  Cost of revenue increased from $9,500,000 in fiscal year 2003 to $19,743,000 in fiscal year 2004, which was primarily attributable to increased legal fees incurred in connection with our SCO Litigation.  Operating expenses for sales and marketing, research and development and general and administrative increased in fiscal year 2004 over fiscal year 2003 as certain employees were dedicated to this business initiative in fiscal year 2004.  The other expense in fiscal year 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.

 

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

 

Because of the uncertainties related to our SCOsource business, we are unable to estimate the amount and timing of future SCOsource licensing revenue.  This uncertainty represents a significant risk and challenge for us, both in the short and long term.  If we do receive revenue from this source, it may be sporadic and fluctuate from quarter to quarter.  Our SCOsource initiatives are unlikely to produce a

 

21



 

stable or predictable revenue stream for the foreseeable future.  We are unlikely to generate significant revenue from our SCOsource business unless and until we prevail in our SCO Litigation.  Additionally, the success of these initiatives may depend on the strength of our intellectual property rights and contractual claims regarding UNIX, including the strength of our claim that unauthorized UNIX source code and derivative works are contained in Linux.

 

Critical Accounting Estimates

 

The preparation of financial statements and related disclosures in conformity with generally accepted accounting principles in the United States 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 1 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;

 

                              Fair value of derivative financial instrument and our now retired Series A-1 Convertible Preferred Stock;

 

                              Severance and exit costs;

 

                              Impairment of long-lived assets; and

 

                              Allowances for doubtful accounts.

 

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

 

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

 

22



 

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

 

Deferred Income Taxes and Related Valuation Allowance.  The amount, and ultimate realization, of our deferred income tax assets depends, in part, upon the tax laws in effect, our future earnings and other future events, the effects of which cannot be determined.  We have provided a valuation allowance of $66,655,000 against our entire net deferred tax asset as of October 31, 2004.  The valuation allowance was recorded because of our history of net operating losses and the uncertainties regarding our future operating profitability and taxable income.

 

Fair Value of Derivative Financial Instrument and Our Retired Series A-1 Convertible Preferred Stock.  In October 2003, we issued 50,000 shares of our redeemable Series A Convertible Preferred Stock.  The terms of the preferred stock included conversion and a number of redemption provisions that represented a derivative financial instrument under Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended.  We determined that the conversion feature was an embedded derivative financial instrument.

 

As of October 16, 2003, through the assistance of an independent valuation firm, we determined the initial fair value of the derivative was classified as a current liability $18,069,000 and the value of the preferred stock was $29,671,000.  We were required to account for the conversion feature as an embedded derivative since the preferred stock instrument did not entitle the holders to equity features such as voting rights and board representation.  As of October 31, 2003, the fair value of the derivative was $15,224,000 and the decrease in fair value of $2,845,000 was recorded as income as a change in fair value of derivative in other income in the statement of operations for fiscal year 2003.  During fiscal year 2004, the fair value of the derivative decreased and we recorded a total of $5,924,000 as income as a change in fair value of the derivative in other income.

 

On February 5, 2004, we completed an exchange transaction in which each outstanding Series A share was exchanged for one share of redeemable Series A-1 Convertible Preferred Stock.  We received no additional proceeds in the exchange.  The exchange transaction eliminated the derivative related to the Series A shares that was initially recorded as a current liability on our balance sheet and eliminated the charge in our quarterly statements of operations for the change in the fair value of the derivative related to the Series A shares.

 

Through the assistance of an independent valuation firm, we determined the fair value of the Series A-1 shares to be $45,276,000 as of February 5, 2004.  We recorded a dividend in the second quarter of fiscal year 2004 of $6,305,000, which reduced earnings available to common stockholders, related to the difference between the fair value of the Series A-1 shares and the carrying value of the previously issued Series A shares and related derivative.  This dividend was only one component of the total dividends recorded in fiscal year 2004.

 

The estimated fair value of the Series A-1 shares as of February 5, 2004 was calculated using a binomial model.  Specific assumptions used included:  2.7 years to maturity, 11 percent equivalent bond yield, risk-free rate of 2.4 percent and volatility of 130 percent.  Had different assumptions been used, the valuation result could have been different than reported, and that difference could have been material.  As described elsewhere in this filing, we repurchased all outstanding Series A-1 shares on July 21, 2004.  As of October 31, 2004, no Series A-1 shares remain outstanding.

 

23



 

Severance and Exit Costs.  Since fiscal year 2001, we have undertaken significant restructuring activities to reduce our ongoing cost of operations.  All restructurings that occurred prior to fiscal year 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 fiscal year 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 book value of an asset may not be recoverable.  We evaluate, at each balance sheet date, whether events and circumstances have occurred which indicate possible impairment.  The carrying value of a long-lived asset is considered impaired when the anticipated cumulative undiscounted cash flows of the related asset or group of assets is less than the carrying value.  In that event, a loss is recognized based on the amount by which the carrying value exceeds the estimated fair market value of the long-lived asset.

 

We performed an impairment analysis as of April 30, 2004 in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” and SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and determined that the goodwill and intangible assets related to the Vultus technology, which we acquired from Vultus, Inc. (“Vultus”) in June 2003, had been impaired.  We concluded that an impairment-triggering event occurred during the second quarter of fiscal year 2004 as we had a reduction in force that impacted our ability to move the Vultus initiative forward on a stand-alone basis and an anticipated partnership that would have solidified the Vultus revenue and cash flow did not materialize.  Consequently, we concluded that no significant future cash flows related to our Vultus assets would be realized.  As a result of these analyses, we wrote-down the carrying value of our goodwill related to the Vultus acquisition from $1,166,000 to $0 and wrote-down intangible assets related to our Vultus acquisition from $973,000 to $0.

 

Based on continued declines in our operating results, we performed an additional impairment analysis as of October 31, 2004 and determined that the fair value of our remaining intangible 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,

 

24



 

which is determined based on our historical experience and a specific review of customer balances, was $136,000 as of October 31, 2004.  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 fiscal years ended October 31, 2004, 2003 and 2002 (in thousands):

 

 

 

Years Ended October 31,

 

Statement of Operations Data:

 

2004

 

2003

 

2002

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

Products

 

$

35,352

 

$

45,028

 

$

52,975

 

SCOsource licensing

 

829

 

25,846

 

 

Services

 

6,628

 

8,380

 

11,266

 

Total revenue

 

42,809

 

79,254

 

64,241

 

Cost of revenue:

 

 

 

 

 

 

 

Products

 

3,221

 

4,068

 

7,558

 

SCOsource licensing

 

19,743

 

9,500

 

 

Services

 

4,134

 

6,354

 

10,758

 

Total cost of revenue

 

27,098

 

19,922

 

18,316

 

Gross margin

 

15,711

 

59,332

 

45,925

 

Operating expenses:

 

 

 

 

 

 

 

Sales and marketing

 

17,038

 

24,392

 

29,554

 

Research and development

 

10,612

 

11,012

 

17,558

 

General and administrative

 

7,626

 

6,230

 

9,307

 

Severance and exit costs

 

3,168

 

498

 

6,728

 

Amortization of intangibles

 

2,566

 

3,190

 

2,853

 

Loss on disposition and impairment of long-lived assets

 

2,355

 

164

 

1,796

 

Write-off of investments

 

 

250

 

1,180

 

Stock-based compensation

 

919

 

1,204

 

1,125

 

Compensation to law firms

 

 

8,956

 

 

Total operating expenses

 

44,284

 

55,896

 

70,101

 

Income (loss) from operations

 

(28,573

)

3,436

 

(24,176

)

Equity in income (losses) of affiliates

 

111

 

(62

)

(50

)

Other income (expense), net

 

6,507

 

2,827

 

(168

)

Provision for income taxes

 

(1,395

)

(774

)

(483

)

Net income (loss)

 

(23,350

)

5,427

 

(24,877

)

 

 

 

 

 

 

 

 

Dividends on redeemable convertible preferred stock

 

7,123

 

(123

)

 

Net income available (loss applicable) to common stockholders

 

$

(16,227

)

$

5,304

 

$

(24,877

)

 

Fiscal Years Ended October 31, 2004, 2003 and 2002

 

Revenue

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

42,809,000

 

(46

)%

$

79,254,000

 

23

%

$

64,241,000

 

 

Revenue for fiscal year 2004 decreased by $36,445,000, or 46 percent, from fiscal year 2003.  This decrease was primarily attributable to significantly lower SCOsource licensing revenue in the 2004 fiscal

 

25



 

year compared to the 2003 fiscal year as well as a continued decline in our UNIX business.  Revenue for fiscal year 2003 increased by $15,013,000, or 23 percent, from fiscal year 2002, and this increase was primarily attributable to vendor license fees generated from our SCOsource licensing initiatives offset by decreases in UNIX products and services revenue.

 

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

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

UNIX revenue

 

$

41,980,000

 

(21

)%

$

53,408,000

 

(17

)%

$

64,241,000

 

Percent of total revenue

 

98

%

 

 

67

%

 

 

100

%

SCOsource revenue

 

829,000

 

(97

)%

25,846,000

 

n/a

 

 

Percent of total revenue

 

2

%

 

 

33

%

 

 

0

%

 

The decrease in revenue in the UNIX business of $11,428,000 for fiscal year 2004 compared to fiscal year 2003 and the decrease of $10,833,000 for fiscal year 2003 compared to fiscal year 2002 was primarily attributable to continued competition from other operating systems, particularly Linux.  We anticipate that for fiscal year 2005 our total UNIX revenue will decline from UNIX revenue generated in fiscal year 2004.

 

The decrease in SCOsource licensing revenue of $25,017,000 in fiscal year 2004 from fiscal year 2003 was primarily attributable to minimal vendor licensing revenue in fiscal year 2004 compared to significant vendor licensing revenue generated in fiscal year 2003 as a result of two large vendor licenses.

 

Sales of our UNIX products and services during fiscal year 2004 were primarily to pre-existing customers.  Our UNIX business revenue depends significantly on our ability to market our products to existing customers and to generate upgrades from existing customers.  Our UNIX revenue may be lower than currently anticipated if we are not successful with our existing customers or if we lose the support of any of our existing hardware and software vendors or our key industry partners withdraw their marketing and certification support or direct their support to our competitors.  This may occur as a result of the decline of our UNIX business and our SCOsource initiatives.

 

Products Revenue

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Products revenue

 

$

35,352,000

 

(21

)%

$

45,028,000

 

(15

)%

$

52,975,000

 

Percent of total revenue

 

83

%

 

 

57

%

 

 

82

%

 

Our products revenue consists of software licenses for UNIX products such as OpenServer and UnixWare, as well as sales of UNIX-related products.  Products revenue also includes revenue derived from OEMs, 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 $9,676,000 from fiscal year 2004 compared to fiscal year 2003 and the decrease of $7,947,000 from fiscal year 2003 compared to fiscal year 2002 was primarily attributable to decreased sales of OpenServer and UnixWare products primarily resulting from increased competition in the operating system market, particularly Linux.  We believe that this competition from Linux will continue in fiscal year 2005 and future periods.

 

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

 

26



 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

OpenServer revenue

 

$

18,467,000

 

(17

)%

$

22,162,000

 

(24

)%

$

29,108,000

 

Percent of products revenue

 

52

%

 

 

49

%

 

 

55

%

UnixWare revenue

 

11,125,000

 

(21

)%

14,083,000

 

(0

)%

14,154,000

 

Percent of products revenue

 

32

%

 

 

31

%

 

 

27

%

Other products revenue

 

5,760,000

 

(34

)%

8,783,000

 

(10

)%

9,713,000

 

Percent of products revenue

 

16

%

 

 

20

%

 

 

18

%

 

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

 

SCOsource Licensing Revenue

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

SCOsource licensing revenue

 

$

829,000

 

(97

)%

$

25,846,000

 

n/a

 

$

 

Percent of total revenue

 

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 $829,000 in fiscal year 2004, down significantly from revenue of $25,846,000 generated in fiscal year 2003.  We did not generate any revenue from this source in fiscal year 2002.  The SCOsource revenue in fiscal year 2004 was primarily attributable to SCOsource IP license sales and the SCOsource licensing revenue in fiscal year 2003 was primarily attributable to fees associated with two significant vendor licenses.  We believe and allege that our decrease in revenue in fiscal year 2004 was in part attributable to our outstanding dispute with Novell over our 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

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Services revenue

 

$

6,628,000

 

(21

)%

$

8,380,000

 

(26

)%

$

11,266,000

 

Percent of total revenue

 

15

%

 

 

11

%

 

 

18

%

 

Services revenue consists primarily of annual and incident technical support fees, engineering services fees, professional services and consulting fees, and education fees.  These fees are typically charged and invoiced separately from UNIX products sales.  The decrease in services revenue of $1,752,000, or 21 percent, from fiscal year 2003 as compared to fiscal year 2004 as well as the decrease in services revenue in fiscal year 2002, compared to fiscal year 2003 of $2,886,000, or 26 percent, was in part due to the decrease in products revenue as well as fewer customers renewing services agreements.

 

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

 

Cost of Products Revenue

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of products revenue

 

$

3,221,000

 

(21

)%

$

4,068,000

 

(46

)%

$

7,558,000

 

Percentage of products revenue

 

9

%

 

 

9

%

 

 

14

%

 

27



 

Cost of products revenue consists of manufacturing costs, royalties to third-party vendors, technology costs and overhead costs.  Cost of products revenue decreased by $847,000, or 21 percent, in fiscal year 2004 as compared to fiscal year 2003 and decreased by $3,490,000, or 46 percent, in fiscal year 2003 compared to fiscal year 2002.  This decrease in cost of products revenue was primarily attributable to lower products revenue, lower manufacturing costs, decreased royalties to third party vendors and lower amortized technology costs.

 

For fiscal year 2005, we expect the dollar amount of our cost of products revenue to be less than in fiscal year 2004 and, as a percentage of products revenue, to be consistent with the percentage achieved during fiscal year 2004.

 

Cost of SCOsource Licensing Revenue

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of SCOsource licensing revenue

 

$

19,743,000

 

108

%

$

9,500,000

 

n/a

 

$

 

Percentage of SCOsource licensing revenue

 

2382

%

 

 

37

%

 

 

 

 

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 $10,243,000, or 108 percent, during fiscal year 2004 as compared to fiscal year 2003.  The increase in costs in fiscal year 2004 compared to fiscal year 2003 was primarily attributable to increased legal costs incurred in connection with our SCO Litigation.

 

With the completion of the Engagement Agreement with the Law Firms representing us in our SCO Litigation as described elsewhere in this filing, we anticipate that the dollar amount of our cost of SCOsource licensing for fiscal year 2005 will be lower than fiscal year 2004.  However, future legal fees may include contingency payments made to the Law Firms as a result of a settlement, judgment, certain licensing fees or a sale of our company, which could cause cost of SCOsource licensing revenue for fiscal year 2005 to be higher than fiscal year 2004.

 

Cost of Services Revenue

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of services revenue

 

$

4,134,000

 

(35

)%

$

6,354,000

 

(41

)%

$

10,758,000

 

Percentage of services revenue

 

62

%

 

 

76

%

 

 

95

%

 

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 $2,220,000, or 35 percent, for fiscal year 2004 compared to fiscal year 2003 and decreased by $4,404,000, or 41 percent, for fiscal year 2003 compared to fiscal year 2002.  This decrease was attributable to reduced employee and related costs and the elimination of certain third-party support contracts.

 

For fiscal year 2005, we expect the dollar amount of our cost of services revenue to be less than that incurred in fiscal year 2004 and that cost of services revenue as a percentage of services revenue will be lower in fiscal year 2005 as compared to fiscal year 2004.

 

28



 

Sales and Marketing

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing expense

 

$

17,038,000

 

(30

)%

$

24,392,000

 

(17

)%

$

29,554,000

 

Percentage of total revenue

 

40

%

 

 

31

%

 

 

46

%

 

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 $7,354,000, or 30 percent, from fiscal year 2003 to fiscal year 2004 and the decrease from fiscal year 2002 to fiscal year 2003 of $5,162,000, or 17 percent, was primarily attributable to reductions in sales and marketing employees, reduced travel expenses, less commissions and lower advertising costs.  Sales and marketing expense as a percentage of revenue increased during fiscal year 2004 as compared to fiscal year 2003 as a result of lower revenue in the 2004 fiscal year.  Our sales and marketing full-time equivalent employees decreased from 133 as of October 31, 2002, to 114 as of October 31, 2003, to 62 as of October 31, 2004.

 

For fiscal year 2005, we anticipate that the dollar amount of sales and marketing expense will decrease from fiscal year 2004.

 

Research and Development

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development expense

 

$

10,612,000

 

(4

)%

$

11,012,000

 

(37

)%

$

17,558,000

 

Percentage of total revenue

 

25

%

 

 

14

%

 

 

27

%

 

Research and development expenses consist of the salaries and benefits of software engineers, consulting expenses and corporate allocations.  Research and development expense decreased by $400,000, or 4 percent, from fiscal year 2004 compared to fiscal year 2003.  During fiscal year 2004 our engineering efforts were focused on the release of UnixWare 7.1.4 and the continued development of the next release for our OpenServer product.  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.  The decrease in research and development expense in fiscal year 2003 of $6,546,000, or 37 percent, compared to fiscal year 2002 was primarily attributable to work force reductions.  Research and development expense as a percentage of revenue increased in fiscal year 2004 as compared to fiscal year 2003 as a result of lower revenue in fiscal year 2004.  Our research and development full-time equivalent employees decreased from 75 for fiscal years ended October 31, 2002 and 2003 to 64 as of October 31, 2004.

 

For fiscal year 2005, we anticipate that the dollar amount of research and development expenses will decrease from fiscal year 2004.

 

General and Administrative

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative expense

 

$

7,626,000

 

22

%

$

6,230,000

 

(33

)%

$

9,307,000

 

Percentage of total revenue

 

18

%

 

 

8

%

 

 

14

%

 

General and administrative expenses consist 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 increased by $1,396,000, or 22 percent, during fiscal year 2004 as compared to fiscal year 2003.  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

 

29



 

other professional service providers.  The decrease in general and administrative expense from fiscal year 2002 to fiscal year 2003 of $3,077,000, or 33 percent, was primarily attributable to staff centralization.  General and administrative expenses as a percent of total revenue increased in fiscal year 2004 as a result of increased costs and lower revenue.  Our general and administrative full-time equivalent employees decreased from 61 as of October 31, 2002, to 55 as of October 31, 2003, to 36 as of October 31, 2004.

 

For fiscal year 2005, we anticipate that the dollar amount of general and administrative expenses will decrease from fiscal year 2004.  However, due to the new compliance and reporting regulations under the Sarbanes-Oxley Act and other new regulatory requirements, general and administrative expenses may vary as we implement policies and procedures to comply with these new requirements.

 

Severance and Exit Costs

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Severance and exit costs

 

$

3,168,000

 

536

%

$

498,000

 

(93

)%

$

6,728,000

 

Percentage of total revenue

 

7

%

 

 

1

%

 

 

10

%

 

During fiscal years 2004, 2003 and 2002, we recorded severance and exit costs totaling $3,168,000, $498,000 and $6,728,000, respectively.  The severance and exit costs for fiscal years 2004, 2003 and 2002 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.  The variation in severance and exit costs from fiscal year 2004 compared to fiscal year 2003 and from fiscal year 2003 compared to fiscal year 2002 is a result of the number of terminated employees and the size and number of facilities closed.

 

The detail of the severance and exit costs for fiscal years 2004, 2003 and 2002, are as follows (in thousands):

 

Fiscal 2004

 

Balance at
November 1, 2003

 

Additions

 

Adjustments

 

Utilization

 

Balance at
October 31, 2004

 

 

 

 

 

 

 

 

 

 

 

 

 

One-time severance

 

$

 

$

309

 

$

 

$

(309

)

$

 

Ongoing severance and other

 

 

2,071

 

 

(1,670

)

401

 

Facilities

 

348

 

788

 

 

(1,136

)

 

Total

 

$

348

 

$

3,168

 

$

 

$

(3,115

)

$

401

 

 

Fiscal 2003

 

Balance at
November 1, 2002

 

Additions

 

Adjustments

 

Utilization

 

Balance at
October 31, 2003

 

 

 

 

 

 

 

 

 

 

 

 

 

One-time severance

 

$

 

$

198

 

$

 

$

(198

)

$

 

Ongoing severance and other

 

560

 

1,388

 

(273

)

(1,675

)

 

 

Facilities

 

2,117

 

 

(815

)*

(954

)

348

 

Total

 

$

2,677

 

$

1,586

 

$

(1,088

)

$

(2,827

)

$

348

 

 


* 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.

 

Fiscal 2002

 

Balance at
November 1, 2001

 

Additions

 

Adjustments

 

Utilization

 

Balance at
October 31, 2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Severance and other

 

$

692

 

$

4,053

 

$

 

$

(4,185

)

$

560

 

Facilities

 

2,052

 

4,236

 

(1,561

)*

(2,610

)

2,117

 

Total

 

$

2,744

 

$

8,289

 

$

(1,561

)

$

(6,795

)

$

2,677

 

 

30



 


*The facilities adjustment of $1,561,000 was the result of successfully re-negotiating an existing lease commitment.

 

Amounts to be paid for severance and exit costs are included as accrued liabilities.

 

Amortization of Intangibles

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortization of intangibles

 

$

2,566,000

 

(20

)%

$

3,190,000

 

12

%

$

2,853,000

 

Percentage of total revenue

 

6

%

 

 

4

%

 

 

4

%

 

During fiscal years 2004, 2003 and 2002, we recorded $2,566,000, $3,190,000 and $2,853,000, respectively, for the amortization of intangible assets with finite lives.  The decrease of $624,000, or 20 percent, from fiscal year 2004 compared to fiscal year 2003 was primarily attributable to reduced amortization expense recorded on certain assets acquired from Vultus that were written down to $0 during fiscal year 2004 and therefore were not amortized for the last half of fiscal year 2004.  The increase of $337,000 in fiscal year 2003 over fiscal year 2002 was attributed to amortization expense on assets acquired from Vultus.

 

Loss on Disposition and Impairment of Long-lived Assets

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

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

 

$

2,355,000

 

1336

%

$

164,000

 

(91

)%

$

1,796,000

 

Percentage of total revenue

 

6

%

 

 

0

%

 

 

3

%

 

During fiscal years 2004, 2003 and 2002, we recorded a write down of long-lived assets of $2,355,000, $164,000 and $1,796,000, respectively.  The loss on disposition and write-down of long-lived assets recorded in fiscal year 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 fiscal year 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 have 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 in fiscal years 2003 and 2002 were primarily attributable to assets written off in connection with restructurings that occurred during each fiscal year.

 

Write-offs of Investments

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Write-offs of investments

 

$

 

n/a

 

$

250,000

 

(79

)%

$

1,180,000

 

Percentage of total revenue

 

0

%

 

 

0

%

 

 

2

%

 

Management routinely assesses our investments for impairments and adjusts the carrying amounts to estimated realizable values when impairment has occurred.  During fiscal year 2004, we did not have any write-offs of investments.  During fiscal year 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.

 

During fiscal year 2002, we determined that the current carrying value of $1,180,000 related to our investment in Lineo, Inc. (“Lineo”) would not be recovered and was written off.  This write-off was

 

31



 

due to a significant deterioration in the operating results of Lineo and declines in general economic conditions.  This investment had been accounted for under the cost method.

 

Stock-based Compensation

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation

 

$

919,000

 

(24

)%

$

1,204,000

 

7

%

$

1,125,000

 

Percentage of total revenue

 

2

%

 

 

2

%

 

 

2

%

 

Stock-based compensation consisted of the following components for fiscal years 2004, 2003 and 2002 (in thousands):

 

 

 

2004

 

2003

 

2002

 

 

 

 

 

 

 

 

 

Amortization of stock-based compensation

 

$

325

 

$

866

 

$

986

 

Reversal of previously recorded expense related to terminated employees

 

 

 

(565

)

Options, warrants and shares for services

 

502

 

296

 

631

 

Modifications to options

 

92

 

42

 

73

 

Total

 

$

919

 

$

1,204

 

$

1,125

 

 

As of October 31, 2004, there was a balance of approximately $22,000 in deferred compensation that will be amortized to stock-based compensation during fiscal year 2005.

 

Compensation to Law Firms

 

 

 

2004

 

Change

 

2003

 

Change

 

2002

 

 

 

 

 

 

 

 

 

 

 

 

 

Compensation to law firms

 

$

 

n/a

 

$

8,956,000

 

n/a

 

$

 

Percentage of total revenue

 

0

%

 

 

11

%

 

 

0

%

 

During fiscal year 2003, we incurred contingency fees of $8,956,000, or 11 percent 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 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, 2004, the carrying value of our investments was related to our 30 percent ownership in a Chinese company.

 

During fiscal years 2004, 2003 and 2002, we recorded $111,000, ($62,000) and ($50,000), respectively, that related to net income (losses) in these entities.  The income reported in fiscal year 2004 was attributable to our portion of the net income generated by the above mentioned Chinese company.  The losses in the 2003 and 2002 fiscal years were primarily attributable to losses generated from Vista.

 

Other Income (Expense), net

 

Other income (expense) consisted of the following components for fiscal years 2004, 2003 and 2002 (in thousands):

 

32



 

 

 

2004

 

2003

 

2002

 

 

 

 

 

 

 

 

 

Interest income

 

$

905

 

$

188

 

$

377

 

Interest expense

 

 

(3

)

(206

)

Change in fair value of derivative

 

5,924

 

2,845

 

 

Other expense, net

 

(322

)

(203

)

(339

)

Total other income (expense), net

 

$

6,507

 

$

2,827

 

$

(168

)

 

Interest income increased by $717,000 from fiscal year 2003 to fiscal year 2004 and decreased by $189,000 from fiscal year 2003 to fiscal year 2002.  The changes in interest income are the result of changes in our cash and available-for-sale securities balances.

 

 Interest expense decreased by $203,000 from fiscal year 2002 compared to fiscal year 2003 as a result of interest expense recorded in the 2002 fiscal year on our outstanding note payable to The Santa Cruz Operation.  This note payable was paid during fiscal year 2002.

 

The income recorded on the change in fair value of derivative for fiscal year 2004 and fiscal year 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 second quarter of fiscal year 2004.

 

Provision for Income Taxes

 

The provision for income taxes was $1,395,000 in fiscal year 2004, $774,000 in fiscal year 2003 and $483,000 in fiscal year 2002.  The increase in the provision for income taxes of $621,000 in fiscal year 2004 compared to fiscal year 2003 was primarily attributable to accruals for withholding taxes that are estimated to be paid in connection with the operations of our Indian operations.  Other than the accrual previously mentioned, our provision for income taxes is primarily related to earnings in foreign subsidiaries.

 

As of October 31, 2004, we had net operating loss carry-forwards for U.S. federal and state income tax reporting purposes of approximately $121,448,000 that expire at various dates between 2019 and 2024.  We had net deferred tax assets, including net operating loss carry-forwards and other temporary differences between book and tax deductions, totaling approximately $67,087,000 as of October 31, 2004.  We also had net deferred tax liabilities of approximately $432,000 related to taxes on foreign earnings.  A valuation allowance in the amount of $66,655,000, the difference between our deferred tax assets and liabilities, has been recorded as of October 31, 2004 as a result of uncertainties regarding the ultimate realizability of the net deferred tax asset balance.

 

Dividends Related to Series A and Series A-1 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 in fiscal year 2004.

 

With the completion of the repurchase transaction with BayStar Capital II, L.P. (“BayStar”) during fiscal year 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 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.

 

33



 

If the repurchase had not occurred, dividends on the Series A-1 shares would have been paid after October 16, 2004, the first anniversary of the original Series A private placement, quarterly at a rate of 8 percent per annum, subject to annual increases of 2 percent per annum, not to exceed 12 percent per annum.  We will no longer accrue dividends on preferred stock because the Series A-1 shares were repurchased.  No dividends were paid on the Series A or Series A-1 shares.

 

The following table details the components of the dividends for fiscal years 2004, 2003 and 2002 (in thousands):

 

 

 

2004

 

2003

 

2002

 

 

 

 

 

 

 

 

 

Accrual of dividends on preferred stock

 

$

(2,047

)

$

(123

)

$

 

Exchange of Series A shares for Series A-1 shares

 

(6,305

)

 

 

Repurchase of Series A-1 shares from BayStar

 

15,475

 

 

 

Total

 

$

7,123

 

$

(123

)

$

 

 

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,
2004

 

April 30,
2004

 

July 31,
2004

 

October 31,
2004

 

 

 

(unaudited)
(In thousands, except per share data)

 

Fiscal Year 2004

 

 

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

Quarter Ended

 

 

 

January 31,
2003

 

April 30,
2003

 

July 31,
2003

 

October 31,
2003

 

 

 

(unaudited)
(In thousands, except per share data)

 

Fiscal Year 2003

 

 

 

 

 

 

 

 

 

Revenue

 

$

13,540

 

$

21,369

 

$

20,055

 

$

24,290

 

Gross margin

 

10,662

 

16,222

 

15,521

 

16,927

 

Income (loss) from operations

 

(738

)

4,925

 

3,410

 

(4,161

)

Net income available (loss applicable) to common stockholders

 

(724

)

4,500

 

3,096

 

(1,568

)

Net income (loss) per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.06

)

$

0.39

 

$

0.25

 

$

(0.12

)

Diluted

 

$

(0.06

)

$

0.33

 

$

0.19

 

$

(0.12

)

Weighted average basic common shares

 

11,244

 

11,561

 

12,469

 

13,371

 

Weighted average diluted common shares

 

11,244

 

13,663

 

16,180

 

13,371

 

 

34



 

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;

 

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

 

                  the level, magnitude and timing of SCOsource license revenue;

 

                  the amount of legal fees 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;

 

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

 

                  changing business attitudes toward UNIX as a viable operating system alternative to other competing systems, especially Linux.

 

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” section 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 equivalents balance decreased from $64,428,000 as of October 31, 2003 to $12,693,000 as of October 31, 2004.  During this same time period, our investment in available-for-sale securities increased from $4,095,000 to $18,756,000.  Total cash and equivalents and available-for sale securities were $31,449,000 as of October 31, 2004.  We also have $5,000,000 classified as a component of restricted cash set aside to cover expert and other costs related to our SCO Litigation.  During fiscal year 2004, we expended a significant amount of cash for our intellectual property litigation and for our UNIX business.

 

During fiscal year 2003, we generated positive cash flow for the first time in our operating history.  This was primarily achieved through significant license revenue generated from our SCOsource business.  We also received cash in fiscal year 2003 from the sale of 50,000 shares of our now retired Series A Convertible Preferred Stock.

 

We intend to use the cash and equivalents and available-for-sale securities as of October 31, 2004 to maintain our UNIX business and pursue our SCO Litigation.  We believe that we will have sufficient cash resources to fund our current operations for the next 12 months.

 

Our net cash used in operations during fiscal year 2004 was $22,604,000 and was attributable to a net loss of $23,350,000, non-cash items of $922,000 and changes in operating assets and liabilities of $176,000.  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 operations during fiscal year 2003 was $12,087,000.  Cash provided by operations was attributable to net income of $5,427,000, non-cash items totaled $11,610,000 and changes in operating assets and liabilities of $4,950,000.  Our long-term liabilities decreased from $1,625,000 to $508,000 during fiscal year 2003.

 

35



 

Cash used in operations during fiscal year 2002 was $10,592,000 and was primarily attributable to the net loss of $24,877,000, partially offset by non-cash items of $10,101,000 and cash provided by changes in operating assets and liabilities of $4,184,000.

 

Our investing activities have historically consisted of equipment purchases, investing in strategic partners and the purchase and sale of available-for-sale securities.  During fiscal year 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 fiscal year 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.

 

During fiscal year 2002, cash provided by investing activities was $5,287,000, which was primarily generated from the sale of $5,943,000 of available-for-sale securities, offset by an investment in a non-marketable security of $350,000, cash paid for the purchase of equipment of $206,000 and payment of $100,000 to The Santa Cruz Operation.

 

Our financing activities used $13,864,000 of cash in fiscal year 2004.  The primary uses of cash were $13,000,000 used 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 the Series A-1 in exchange for outstanding Series A shares.  These uses of cash were offset 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 fiscal year 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 financing activities used $8,998,000 of cash during fiscal year 2002 and consisted primarily of a $5,000,000 payment to retire the note payable to The Santa Cruz Operation and $4,584,000 for the purchase of shares of our common stock held by two investors.  These payments were offset by $291,000 of proceeds received from the exercise of stock options and $295,000 received from employees who purchased shares of our common stock through our employee stock purchase program.

 

Our net accounts receivable balance decreased from $9,282,000 as of October 31, 2003 to $6,638,000 as of October 31, 2004, primarily as a result of lower invoicing and revenue in the fourth quarter of fiscal year 2004 as compared to the fourth quarter of fiscal year 2003.  The majority of our accounts receivable are current and our allowance for doubtful accounts was $136,000 as of October 31, 2004, 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 fiscal years 2004 and 2003 were not significant.

 

On October 31, 2004, we entered into the Engagement Agreement 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 the current litigation between us and 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

 

36



 

approximately $26,000,000 for certain previously accrued expenses, totaling $13,906,000 as of October 31, 2004, and all future attorney fees in connection with the SCO Litigation through the end of the current litigation between us and IBM and the escrow of at least $5,000,000 for the payment of any expert, consulting and other expenses.  As of October 31, 2004, this $5,000,000 was classified as a component of restricted cash.  We paid the $13,906,000 subsequent to October 31, 2004.

 

Future legal fees covered under the Engagement Agreement will require us to pay to the Law Firms $2,000,000 per quarter for each successive quarter beginning September 1, 2004 and ending December 1, 2005 for a total amount of $12,000,000, of which $10,000,000 will be paid in fiscal year 2005.  In the first quarter of fiscal year 2005, we made the quarterly payments for September 2004 as well as December 2004 for a total of $4,000,000.  The payment of these fees has had and will continue to have a material impact on our cash position.

 

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 recovery from our litigation, our intellectual property licensing 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:

 

                  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 fiscal year 2010.

 

The following table summarizes our contractual operating lease obligations and our required payments to the Law Firms as of October 31, 2004:

 

 

 

Total

 

Less than
1 year

 

1 – 3 years

 

More than
3 years

 

 

 

 

 

 

 

 

 

 

 

Operating lease obligations

 

$

4,770,000

 

$

1,714,000

 

$

2,938,000

 

$

118,000

 

Payments to Law Firms

 

24,573,000

 

22,573,000

 

2,000,000

 

 

Total obligations

 

$

29,343,000

 

$

24,287,000

 

$

4,938,000

 

$

118,000

 

 

As of October 31, 2004, we did not have any long-term debt obligations, purchase obligations, other long-term liabilities or material capital lease obligations.

 

Our ability to cut 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 our SCOsource initiatives.  Our SCOsource initiatives may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products.  This

 

37



 

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.

 

As discussed elsewhere above in Part II, Item 7 of this Form 10-K and in the section entitled “Recent Sales of Unregistered Securities” above in Part II, Item 5 of this Form 10-K, we issued shares and granted options under our Equity Compensation Plans without complying with registration or qualification requirements under federal securities laws and the securities laws of certain states.  As a result, certain plan participants have a right to rescind their purchases of shares under the Equity Compensation Plans or recover damages if they no longer own the shares or hold unexercised options, subject to applicable statutes of limitations, and we may make a rescission offer to certain of such plan participants subject to obtaining required regulatory approvals.  Additionally, regulatory authorities may require us to pay fines or they may impose other sanctions on us, and we may face other claims by participants other than rescission claims.

 

If our potential rescission offer is made and accepted by plan participants holding shares acquired under the Equity Compensation Plans or otherwise entitled to recover damages from us in respect of such shares they have sold, or such plan participants otherwise make rescission claims against us, we could be required to make aggregate payments to these plan participants of up to $528,000 in the aggregate, excluding interest and other possible fees, based upon shares outstanding under the Equity Compensation Plans as of October 31, 2004.

 

We may also face additional rescission liability to plan participants holding unexercised stock options in California, Georgia and possibly other states.  Regulatory authorities may require us to pay fines or impose other sanctions on us.  Although we believe that it is reasonably possible that some plan participants holding unexercised options may accept a rescission offer or potentially attempt to enforce a rescission right, we are unable to estimate the number of participants who might pursue rescission or the potential rescission liability we may have to them.  Since any loss is considered reasonably possible but not estimable, we have not recorded a liability for this contingency.

 

We may also be required to pay interest and penalties up to statutory limits in connection with Plan participants making rescission claims or in connection with any rescission offer.  We believe that it is reasonably possible that we may be required to pay interest and penalties, but are not able to estimate an amount.

 

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 our SCOsource initiatives.  We may also not be able to raise capital for any number of reasons including those listed under the section “Risk Factors” below.  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 FASB issued SFAS No. 123R “Share-Based Payment” (“SFAS 123R”), a revision to SFAS No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”), and superseding APB Opinion No. 25 “Accounting for Stock Issued to Employees” and its related implementation guidance.  SFAS 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services, including obtaining employee services in share-based payment transactions.  SFAS 123R applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date.  Adoption of the provisions of SFAS 123R is effective as of the beginning of the first interim or annual reporting period that begins after

 

38



 

June 15, 2005.  We have not yet evaluated the potential impact that the adoption of SFAS 123R will have on our consolidated financial position and 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 operating strategy to continue to support our existing users of our UNIX operating system products and to pursue SCOsource licensing opportunities and protect our intellectual property rights;

 

                              Our intention to continue to maintain our core UNIX business in fiscal year 2005 by continuing our research and development efforts;

 

                              Our belief that our OpenServer and UnixWare products will continue to provide a revenue stream in fiscal year 2005 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 our development resources on our next OpenServer product and maintaining our current UnixWare products;

 

                              Our intention to focus development resources on augmenting our current UNIX products with other products that will solve business problems for our existing installed base of customers;

 

                              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 release OpenServer in the first half of calendar year 2005 and our expectation that our investment in this effort will give customers confidence in our technology;

 

                              Our expectation that developing a 64-bit version of our operating system technology will give customers confidence in their commitment to our technologies;

 

                              Our intention to continue to pursue our SCOsource initiatives in fiscal year 2005;

 

                              Our belief that the future success of our SCOsource initiatives will depend on our ability to protect our intellectual property;

 

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

 

                              Our intention to continue to pursue our litigation against IBM, Novell, AutoZone, and DaimlerChrysler;

 

39



 

                              Our belief that our cash balance will be adequate for us to execute our business strategy as well as to continue to pursue our intellectual property claims 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 in fiscal year 2005 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 expectation of entering into future vendor license agreements with developers, manufacturers, distributors and end users of operating systems;

 

                              Our expectation that product enhancements to improve our UNIX technology will extend the life and improve the functionality of our UNIX products and our belief that such improvements will not result in significant revenue increases;

 

                              Our belief that such product enhancements to our UNIX technology will help prolong our OpenServer revenue stream for future quarters;

 

                              Our intention to continue to review the status of our existing UNIX license agreements with UNIX vendors in fiscal year 2005;

 

                              Our intention to continue to pursue our IP licensing initiative against those that may be violating our UNIX copyrights;

 

                              Our expectation that our UNIX business will generate positive cash flow during fiscal year 2005;

 

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

 

                              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 fiscal year 2005 will decline from UNIX revenue generated in fiscal year 2004;

 

                              Our belief that competition from Linux will continue in fiscal year 2005 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 fiscal year 2005 that the dollar amount of our cost of products revenue will be lower than fiscal year 2004;

 

                              Our expectation for fiscal year 2005 that the dollar amount of our cost of SCOsource licensing revenue will be lower than fiscal year 2004;

 

                              Our expectation for fiscal year 2005 that the dollar amount of our cost of services revenue will be lower than fiscal year 2004;

 

                              Our expectation for fiscal year 2005 that the dollar amount of our sales and marketing expenses will be lower than fiscal year 2004;

 

40



 

                              Our expectation for fiscal year 2005 that the dollar amount of our research and development expenses will be lower than fiscal year 2004;

 

                              Our expectation for fiscal year 2005 that the dollar amount of our general and administrative expenses will be lower than fiscal year 2004;

 

                              Our belief that our legal costs related to our intellectual property litigation will decrease in fiscal year 2005 compared to fiscal year 2004, exclusive of any contingent payments;

 

                              Our belief that our facilities are adequate for our business; 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 SCOsource initiatives, 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” below.  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 these forward-looking statements to reflect new events or circumstances or any changes in our beliefs or expectations, other than as required by law.

 

Risk Factors

 

We do not have a history of profitable operations.

 

Our fiscal year ended October 31, 2003 was the first full year we were profitable in our operating history.  Our profitability in fiscal year 2003 resulted primarily from our SCOsource licensing initiatives.  For fiscal year 2004, we incurred a net loss from operations of $28,573,000 and our accumulated deficit as of October 31, 2004 was $224,216,000.  If we do not receive SCOsource licensing revenue in future quarters and 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 increased competition from alternative operating systems, particularly Linux.  In our quarterly 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 operations will be adversely impacted.

 

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

 

We continue to pursue our SCO Litigation as described in more detail in Item 3 of Part I of this Form 10-K and believe very strongly 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, and several motions are currently

 

41



 

pending before the court.  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 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 our SCO Litigation and our other SCOsource initiatives, several participants in the Linux industry 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 participants in our marketplace will negatively view our action against IBM, Novell, DaimlerChrysler, and AutoZone and our other SCOsource initiatives, 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.   We have also experienced several denial-of-service attacks on our website, which have prevented web users from accessing our website and doing business with us for a period of time.  If such attacks continue or if our customers and strategic partners are also subjected to similar attacks, our business and results of operations could be materially harmed.  In addition, some of the more significant participants in the Linux industry have made efforts to ease Linux end users’ concerns that their use of Linux may subject them to potential copyright infringement claims from us.

 

As a further response to our SCOsource initiatives and 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 also claims that it has a license to UNIX from us and the right to authorize its customers to use UNIX technology in their internal business operations.  Specifically, Novell has also claimed to have retained rights related to legacy UNIX SVRx 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 and waiver rights.  Novell has purported to veto our termination of the IBM, Sequent and SGI licenses. We have repeatedly 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 (now Tarantella, Inc.) in May 2001, which had previously acquired all such assets and rights from Novell in September 1995 pursuant to an asset purchase agreement, as amended.  In January 2004, in response 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 copyrights and contract rights related to our UNIX source code and derivative works and our UnixWare products.  Our lawsuit against Novell is also described in more detail in Item 3 of Part I of this Form 10-K.

 

Notwithstanding our assertions of full ownership of 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 Linux end users to be less willing to purchase from us our SCOsource IP licenses authorizing their use of our intellectual property contained in the Linux operating system, which has and may continue to adversely affect our revenue from our SCOsource initiatives.  These efforts of Linux proponents also may increase the negative view some participants in our marketplace have regarding our SCO Litigation and regarding our SCOsource initiatives 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 infringes on our copyrights.  Increased negative perception

 

42



 

and potential confusion about our claims in our marketplace could impede our continued pursuit of our SCOsource initiatives and negatively impact our business.

 

Our failure to timely file this Form 10-K, and our quarterly report on Form 10-Q for the quarter ended January 31, 2005 (as previously defined, the “Form 10-Q”), could result in the delisting of our common stock on The Nasdaq SmallCap Market.

 

We received notice on February 16, 2005 from The Nasdaq Stock Market that, due to the delay in filing this Form 10-K, we were not, as of such date, in compliance with the filing requirements for continued listing set forth in Marketplace Rule 4310(c)(14), and that our common stock is, therefore, subject to delisting at the opening of business on February 25, 2004.  We requested and participated in a hearing with the Nasdaq Listing Qualifications Panel on March 17, 2005.  At the hearing, we outlined for the Panel our plan for filing this Form 10-K and the Form 10-Q, which also was not filed in a timely fashion.  On March 18, 2005, we received a notice from The Nasdaq Stock Market regarding our potential delisting as a result of our failure to file the Form 10-Q in a timely fashion.  The notice informed us that the Panel will consider the filing delinquency of our Form 10-Q in addition to the filing delinquency of this Form 10-K in rendering its decision regarding our listing status.  We will continue to be listed on The Nasdaq SmallCap Market under the symbol SCOXE pending the issuance of the Panel’s decision.  Although we have filed this Form 10-K, we have not yet filed the Form 10-Q, and there can be no assurance that Nasdaq will not act to delist our common stock from The Nasdaq SmallCap Stock Market.

 

Our Engagement Agreement with the Law Firms will require us to spend a significant amount of cash during fiscal year 2005 and could harm our liquidity position.

 

As of October 31, 2004, we had a total of $31,449,000 in cash and cash equivalents and available-for-sale securities and an additional $5,000,000 as restricted cash to be used in our operations and pursue the SCO Litigation.  As a result of the Engagement Agreement between us and the Law Firms, as described elsewhere in this filing, we anticipate using cash of approximately $27,000,000 in the defense of our intellectual property litigation during fiscal year 2005, which would leave us approximately $9,449,000 in cash for our business operations.  We expect that our UNIX business will generate sufficient cash in fiscal year 2005 to cover our internal costs related to our SCOsource initiatives and intellectual property litigation.  However, if our UNIX business does not generate cash or we spend additional cash on the SCO Litigation or additional matters, our cash position would be negatively impacted, and our ability to pursue our UNIX business objectives and our SCO Litigation would be harmed.

 

Our future SCOsource licensing revenue is uncertain.

 

We initiated the SCOsource licensing effort in fiscal year 2003 to review the status of UNIX licensing and sublicensing agreements.  This effort resulted in the execution of two significant vendor license agreements during fiscal year 2003 and generated $25,846,000 in revenue.  During fiscal year 2004, our SCOsource licensing revenue declined significantly and was only $829,000.  Due to 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.  Our SCOsource initiatives are unlikely to produce stable, predictable revenue for the foreseeable future.  Additionally, the success of these initiatives may depend on the strength of our intellectual property rights and contractual claims regarding UNIX, including the strength of our claim that unauthorized UNIX source code and derivatives are prevalent in Linux.

 

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 SCOsource initiatives may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating

 

43



 

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.

 

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:

 

                                          our 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;

 

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

 

                                          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.

 

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

 

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, Hewlett-Packard, 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 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 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 SCOsource initiatives.

 

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 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

 

45



 

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.

 

Our Engagement Agreement with the Law Firms representing us to enforce our intellectual property rights may reduce our ability to raise additional financing.

 

Our Engagement Agreement with the Law Firms could inhibit our ability to raise additional funding if needed.  Although under the Engagement Agreement our obligations to the Law Firms are limited to approximately $26,000,000 related to certain previously accrued and all future attorney fees and the escrow of $5,000,000 for the payment of any expert, consulting and other expenses to pursue the SCO Litigation, the agreement provides that the Law Firms will receive a contingency fee that may range from 20 to 33 percent of the proceeds from specified events related to the protection of our intellectual property rights.  Events triggering a contingency fee may include settlements or judgments related to the SCO Litigation, certain licensing fees, subject to certain exceptions, and a sale of our company.  Future payments payable to the Law Firms under this arrangement will be significant.  The Law Firms’ right to receive such contingent payments could cause prospective investors to choose not to invest in our company or limit the price at which new investors would be willing to provide additional funds to our company.

 

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.

 

In Latin America and Asia in particular, several countries have suffered and may be especially susceptible to recessions and economic instability, which may lead to increased governmental ownership or regulation of the economy, higher interest rates, increased barriers to entry such as higher tariffs and taxes, and reduced demand for goods manufactured in the United States, resulting in lower revenue.

 

During the second quarter of fiscal year 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 our

 

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packaged software does not qualify for treatment as royalties 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.  If other countries in which we have international operations, such as India, continue to develop and begin enforcing their tax regimes, we may be subject to withholding or other taxes.

 

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

 

We need to retain our 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.

 

We have issued shares and options under our Equity Compensation Plans that were not exempt from registration or qualification under federal and state securities laws, and, as a result, we may incur liability to repurchase such shares and options and may face additional potential claims under federal and state securities laws.

 

We have issued certain shares and granted options under the Equity Compensation Plans without complying with registration or qualification requirements under federal securities laws and the securities laws of certain states.  As a result, certain plan participants that have acquired shares issued under the Equity Compensation Plans have rescission rights against us, subject to applicable statutes of limitations, and we may, subject to obtaining required regulatory approvals, make a rescission offer to certain of such plan participants.  Additionally, regulatory authorities may require us to pay fines or they may impose other sanctions on us, and we may face other claims by plan participants other than rescission claims.

 

If our potential rescission offer is made and accepted by plan participants holding shares acquired under the Equity Compensation Plans or otherwise entitled to recover damages from us in respect of such shares they have sold, or such plan participants otherwise make rescission claims against us, we could be liable to make aggregate payments to these plan participants of up to $528,000 in the aggregate, excluding interest and other possible fees, based upon shares outstanding under the Plans as of October 31, 2004.

 

We may face additional rescission liability to plan participants holding unexercised stock options in California, Georgia and possibly other states.  Additionally, federal securities laws do not provide that a rescission offer will terminate a plan participant’s right to rescind a sale of stock that was not registered as required, and our possible rescission offer may not terminate a plan participant’s right to rescind a sale of stock that was not registered as required under federal law.  If we do not make the planned rescission offer to all plan participants, or any or all of the offerees reject the rescission offer, we may continue to be subject to rescission risk under federal and state securities laws.

 

Our stock price is volatile.

 

The trading price for our common stock has been volatile, ranging from a low closing sales price of $1.09 in mid-February 2003, to a high closing sales price of $20.50 per share in October 2003, to a current sales price of $3.52 on March 29, 2005.  The share price has changed dramatically over short periods.  We believe that the changes in our stock price are affected by 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.

 

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

 

As of March 15, 2005, we have issued and outstanding options to purchase up to approximately 3,481,000 shares of common stock with an average exercise price of $4.18 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 rights may exercise them at a time when we would otherwise be able to obtain additional equity capital on terms more favorable to us.

 

The resale of common shares by BayStar may have an adverse impact on the market value of our stock and the existing holders of our common stock.

 

We previously had an effective registration statement on Form S-3 relating to the sale or distribution by BayStar as a selling stockholder of the 2,105,263 shares of common stock issued to BayStar in connection with our repurchase completed in July 2004 of all Series A-1 shares previously held by BayStar.  When we failed to file this Form 10-K in a timely fashion, we became ineligible to use Form S-3, our registration statement ceased to be effective and BayStar’s ability to resell shares pursuant to that registration statement terminated.  We are currently in the process of preparing a new registration statement for the resale of BayStar’s shares on Form S-1.  Upon that registration statement being declared effective by the SEC, BayStar will again be able to resell its shares.  We will not receive any proceeds from the sales of the shares covered by such registration statement.  The shares that may be sold or distributed pursuant to such registration statement, upon being declared effective by the SEC, will represent approximately 8 percent of our issued and outstanding common stock.  The sale of the block of stock to be covered by such registration statement, or even the possibility of its sale, may adversely affect the trading market for our common stock and reduce the price available in that market.

 

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

 

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

 

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 the Company or a change of control transaction to succeed at current market prices for our stock.

 

We have adopted a Stockholder Rights Plan (“Rights Plan”).  The power given to the Board of Directors by the Rights Plan may make it more difficult for a change of control of our company to occur or for the Company to be acquired when the acquisition is opposed by our Board of Directors.

 

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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.

 

We have in the past utilized foreign currency forward exchange contracts for market exposures of underlying assets and liabilities.  We do not use forward exchange contracts for speculative or trading purposes.  Our accounting policies for foreign exchange contracts are based on our designation of each contract.  The criteria we use for designating each contract include such contract’s effectiveness in risk reduction and one-to-one matching of forward exchange contracts to underlying assets and liabilities.  Gains and losses on currency forward contracts that are firm commitments are deferred and recognized in income in the same period that the underlying transactions are settled.  Gains and losses on currency forward contracts that are designated and effective for existing transactions are recognized in income in the same period as losses and gains on the underlying transactions are recognized and generally offset.  Gains and losses on any instruments not meeting the above criteria are recognized in income in the current period.  As of October 31, 2004, we had no outstanding instruments classified as hedges.

 

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 equivalent sand 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, 2004, our investments balance was approximately $561,000 and was related to our investment in a 30 percent 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 litigation related to our SCOsource initiatives 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.

 

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Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of

The SCO Group, Inc.:

 

We have audited the consolidated balance sheets of The SCO Group, Inc. and subsidiaries as of October 31, 2004 and 2003, and the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity and cash flows for each of the years in the three-year period ended October 31, 2004.  In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule.  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,