Form 10-Q for SCO GROUP INC

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

The following discussion should be read in conjunction with our condensed consolidated financial statements and notes thereto, included elsewhere in this quarterly filing and our annual report on Form 10-K for the year ended October 31, 2002 filed with the Securities and Exchange Commission, including the audited financial statements and management's discussion and analysis contained therein. This discussion contains forward-looking statements that involve risks and uncertainties often indicated by such words as "estimates," "anticipates," "continues," "expects," "intends," "believes" and similar expressions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth below under "Forward-Looking Statements" and "Risk Factors" and elsewhere in this quarterly filing.

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

On May 16, 2003, our stockholders approved our corporate name change to The SCO Group, Inc. ("SCO" or the "Company"). We adopted this name change in response to the continuing brand recognition related to the SCO OpenServer and SCO UnixWare product lines. As used herein, the "Company" or "us," "we," "ours," or similar terms refer to The SCO Group, Inc. and our operating subsidiaries.

During the quarter ended July 31, 2003, we completed the acquisition of the assets of Vultus, Inc. a company engaged in the web services interface business in exchange for the issuance of 305,274 shares. We assumed liabilities of approximately $215,000 in connection with the acquisition, and extended employment offers to substantially all of Vultus' prior employees. We anticipate that the acquired technology and expertise will contribute to the products and services we intend to offer under our web services strategy.

During recent quarters, we have experienced a decline in our product and services revenue primarily attributed to the worldwide economic slowdown, lower information technology spending and increased competition in the operating system market. However, we have implemented cost reduction measures to decrease personnel and excess facilities costs and have significantly reduced our overall operating expenses. These measures, combined with revenue of $15,530,000 from our SCOsource licensing initiative, have resulted in the first two profitable quarters in our history.

Among the assets we acquired from Tarantella, were source code, copy rights and contracts to UNIX. These rights had initially been developed by AT&T Bell Labs and include over 30,000 licensing and sublicensing agreements that have been entered into with approximately 6,000 entities. These licenses led to the development of several proprietary UNIX-based operating systems, including but not limited to our own SCO UnixWare and SCO OpenServer,

Sun's Solaris, IBM's AIX, SGI's IRIX, HP's UX, Fujitsu's ICL DRS/NX, Siemens' SINIX, Data General's DG-UX, and Sequent's DYNIX/Ptx. We believe these operating systems are all derivatives of the original UNIX source code owned by us.

We initiated the SCOsource effort to review the status of these existing licensing and sublicensing agreements and to identify others in the industry that may be currently using our intellectual property without obtaining the necessary licenses. This effort resulted in the execution of two license agreements during the April 30, 2003 quarter. The first of these licenses was with Sun Microsystems, Inc. ("Sun"), a long-time licensee of the UNIX source code and a major participant in the UNIX industry, and was a "clean-up" license to cover items that were outside the scope of Sun's initial UNIX license. The second license was to Microsoft Corporation ("Microsoft"), and covers Microsoft's UNIX compatible products, subject to certain specified limitations. The Sun and Microsoft license agreements are non-exclusive, perpetual, paid up licenses to utilize the UNIX source code.

The amount that we receive from any such licensee will generally depend on the license rights that the licensee previously held and the amount and level of our intellectual property the licensee desires to license. The two licensing agreements signed by us to date resulted in revenue of $8,250,000 during the April 30, 2003 quarter and $7,280,000 during the July 31, 2003 quarter. The license agreement with Sun provides for an additional $2,500,000 to be paid to us by November 2003. On July 31, 2003, Microsoft exercised an option to acquire expanded licensing rights. Upon delivery, we expect to recognize additional revenue related to this option.

In connection with the payment of $2,500,000 to us by Sun during the quarter ended July 31, 2003, we granted a warrant to Sun to purchase up to 12,500 shares of our common stock, for a period of five years, at a price of $1.83 per share. This warrant was valued at $150,000 using the Black-Scholes option-pricing model and reduced our licensing revenue for the quarter ended July 31, 2003 by that amount.

During the course of the review of our intellectual property rights, we became concerned generally about the existence of UNIX source code in the Linux operating system. We have alleged that UNIX source code and unauthorized derivatives of UNIX source code are prevalent in Linux. In March 2003, we filed a complaint against IBM alleging, in part, that it had breached its license agreement with us by, among other things, inappropriately contributing UNIX source code to the open source community and seeking to use its knowledge and methods with respect to UNIX source code and derivative works and modifications licensed to it to destroy the value of the UNIX operating system in favor of promoting the adoption by businesses of the Linux operating system, of which it has been a major backer. Based on these breaches, we terminated the license agreement we have with IBM that permitted the use of our UNIX source code in the development of IBM's AIX operating system. In May 2003, we sent letters to approximately 1,500 large corporations notifying them that the use of the Linux operating system may be a violation of our intellectual property rights.

Subsequent to July 31, 2003, we terminated the UNIX license agreement we had with Sequent Computer Systems, Inc. ("Sequent") (which was previously acquired by IBM) based on similar breaches we had claimed against IBM. This license was the basis for Sequent's UNIX-based offering, the DYNIX /Ptx operating system.

In August 2003, we were sued by Red Hat Inc. ("Red Hat"), seeking, among other things, a declaratory judgment that Linux does not infringe on our intellectual property rights.

The success of our SCOsource licensing initiative, at least initially, will depend to a great extent on the perceived strength of our intellectual property and contractual claims and our willingness to enforce our rights. Many, particularly those in the open source community, dispute the allegations of infringement that we have made.

While our SCOsource initiative has already resulted in revenue of $15,530,000 during the last two quarters and we continue negotiations with other industry participants that we believe may lead to additional SCOsource license agreements, we are currently unable to predict the level or timing of future revenue from this source, if any.

Revenue Revenue was $20,055,000 for the third quarter of fiscal year 2003, and $15,384,000 for the third quarter of fiscal year 2002, representing an increase of $4,671,000, or 30 percent. This increase was attributable to $7,280,000 in licensing revenue, which was the second consecutive quarter we generated revenue from our SCOsource licensing initiative, offset by a decline in product revenue of $1,835,000 and a decline in services revenue of $774,000. Revenue was $54,964,000 for the first three quarters of fiscal year 2003, and $48,773,000 for the first three quarters of fiscal year 2002, representing an increase of $6,191,000, or 13 percent. This increase was attributable to $15,530,000 in licensing revenue, offset by a decline in product revenue of $7,135,000 and a decline in services revenue of $2,204,000.

As discussed above in Recent Developments, we are unable to predict the level of licensing revenue we may recognize in future periods. During the first three quarters of fiscal year 2003, our product and service revenue continued to be adversely impacted by the continuing worldwide economic slowdown and from the related decrease in information technology spending, as well as from increased competition from other operating system products. Additionally, our SCOsource activities and initiatives and our recent announcements regarding Linux, may be causing customers to lengthen their purchase and implementation cycle as they contemplate the appropriate operating platform of the future and assess the current risks related to Linux. We have also seen a decline in our deferred revenue from October 31, 2002 to July 31, 2003, and as a result, our future revenue may be adversely impacted.

Excluding licensing revenue from SCOsource, revenue from international customers accounted for 45 percent of operating system platform revenue for the third quarter of fiscal year 2003 and 48 percent for the third quarter of fiscal year 2002, and revenue from international customers accounted for 47 percent of operating system platform revenue for the first three quarters of fiscal year 2003 and 49 percent for the first three quarters of fiscal year 2002. The decrease in international revenue for the third quarter and for the first three quarters of fiscal year 2003 compared to the third quarter and for the first three quarters of fiscal year 2002 is primarily attributable to decreased revenue in our Europe, Middle East and Africa ("EMEA") region as a result of the prolonged economic slow down in these areas.

Products. Products revenue was $10,804,000 for the third quarter of fiscal year 2003 and $12,639,000 for the third quarter of fiscal year 2002, representing a decrease of $1,835,000, or 15 percent, and representing a slight decrease in products revenue from our second quarter of fiscal year 2003. Products revenue was $33,016,000 for the first three quarters of fiscal year 2003 and $40,151,000 for the first three quarters of fiscal year 2002, representing a decrease of $7,135,000, or 18 percent.

The decrease in products revenue during the third quarter of fiscal year 2003 from the third quarter of fiscal year 2002 as well as during the first three quarters of fiscal year 2003 from the first three quarters of fiscal year 2002 was attributable to decreased sales of OpenServer and UnixWare products primarily resulting from a decrease in information technology spending caused by the worldwide economic slowdown, increased competition from other alternate operating platforms, and uncertainty from our recent Linux announcement. This impact was largely felt in our distribution channel in the Americas and Europe.

OpenServer and UnixWare products continue to be the largest components of our products revenue. For the third quarter of fiscal year 2003, OpenServer revenue was $5,243,000 or 49 percent of total products revenue and UnixWare revenue was $3,343,000 or 31 percent of total products revenue. For the first three quarters of fiscal year 2003, OpenServer revenue was $15,734,000 or 48 percent of total products revenue and UnixWare revenue was $10,524,000 or 32 percent of total products revenue. We recently announced our intentions to continue to invest in these core UNIX operating systems and believe that the revenue from these products will continue to represent a significant portion of our product revenue for the upcoming quarters.

SCOsource Licensing. SCOsource licensing revenue was $7,280,000 for the third quarter of fiscal year 2003 and $15,530,000 for the first three quarters of fiscal year 2003 as compared to no revenue for the third quarter of fiscal year 2002 and for the first three quarters of fiscal year 2002. This revenue is the result of our intellectual property licensing program, SCOsource, launched in January 2003. We initiated SCOsource for the purpose of protecting the significant intellectual property rights we own surrounding the UNIX source code. The SCOsource licensing revenue in the third quarter of fiscal year 2003 represents additional fees associated with two licenses executed during the April 30, 2003, quarter. Under the terms of our license agreement with Sun, we will receive an additional $2,500,000 by November 2003. The Microsoft agreement granted Microsoft the right to acquire expanded licensing rights, which if exercised would result in additional revenue to us. On July 31, 2003, Microsoft exercised this option. Upon delivery, we expect to recognize the additional revenue related to this option.

Services. Services revenue was $1,971,000 for the third quarter of fiscal year 2003 and $2,745,000 for the third quarter of fiscal year 2002, representing a decrease of $774,000, or 28 percent. Services revenue was $6,418,000 for the first three quarters of fiscal year 2003 and $8,622,000 for the first three quarters of fiscal year 2002, representing a decrease of $2,204,000, or 26 percent. The decrease in services revenue is primarily related to the decrease in our products revenue, since a portion of our services revenue is dependent on products revenue. We have also experienced a decrease in our UNIX-related service offerings as a result of service offerings being bundled together with competitive operating system products, primarily Linux-related offerings. We also experienced a decrease in professional services revenue as we have seen a decrease in the demand for custom enterprise-level projects.

Cost of Products Revenue. Cost of products revenue was $1,284,000 for the third quarter of fiscal year 2003 and $1,577,000 for the third quarter of fiscal year 2002, representing a decrease of $293,000, or 19 percent. Cost of products revenue as a percentage of products revenue was 12 percent for the third quarter of fiscal year 2003 and 12 percent for the third quarter of fiscal year 2002. Cost of products revenue was $3,676,000 for the first three quarters of fiscal year 2003 and $6,398,000 for the first three quarters of fiscal year 2002, representing a decrease of $2,722,000, or 43 percent. Cost of products revenue as a percentage of products revenue was 11 percent for the first three quarters of fiscal year 2003 and 16 percent for the first three quarters of fiscal year 2002.

The decrease in the cost of products revenue as a percentage of revenue for the first three quarters of fiscal year 2003 compared to that same period of fiscal year 2002 was attributable primarily to reduced overhead and manufacturing costs resulting from our cost reduction efforts and decreased royalties to third party vendors. For the fourth quarter of fiscal year 2003, we expect the cost of products revenue as a percentage of products revenue to be consistent with the third quarter of fiscal year 2003.

Cost of SCOsource Licensing Revenue. Cost of SCOsource licensing revenue was $1,712,000 for the third quarter of fiscal year 2003 and, $3,875,000 for the first three quarters of fiscal year 2003 and $0 for the third quarter of fiscal year 2002 and for the first three quarters of fiscal year 2002. Cost of SCOsource licensing revenue as a percentage of SCOsource licensing revenue was 24 percent for the third quarter of fiscal year 2003 and 25 percent for first three quarters of fiscal year 2003. Cost of SCOsource licensing revenue includes the salaries and related personnel costs of internal personnel dedicated to the SCOsource licensing initiative, as well as legal and professional fees incurred in connection with the execution of the licensing agreements and the pursuit and defense of the legal actions surrounding our intellectual property rights. Cost of SCOsource licensing revenue may fluctuate from quarter to quarter depending on the level of legal and professional expenses incurred with the enforcement of our intellectual property. Additionally, we are unable to predict the percentage of cost of SCOsource licensing revenue for future quarters due to the unpredictability of the related licensing revenue.

Cost of Services Revenue. Cost of services revenue was $1,538,000 for the third quarter of fiscal year 2003 and $2,494,000 for the third quarter of fiscal year 2002, representing a decrease of $956,000, or 38 percent. Cost of services revenue as a percentage of services revenue was 78 percent for the third quarter of fiscal year 2003 and 91 percent for the third quarter of fiscal year 2002. Cost of services revenue was $5,008,000 for the first three quarters of fiscal year 2003 and $8,809,000 for the first three quarters of fiscal year 2002, representing a decrease of $3,801,000, or 43 percent. Cost of services revenue as a percentage of services revenue was 78 percent for the first three quarters of fiscal year 2003 and 102 percent for the first three quarters of fiscal year 2002.

The decrease in cost of services revenue as a percentage of services revenue in fiscal year 2003 compared to fiscal year 2002 was attributable to decreased employee and related costs in our support services and professional services organization, decreased costs from external professional services providers and from the elimination of certain third party support contracts.

For the fourth quarter of fiscal year 2003, we expect cost of services revenue as a percentage of services revenue to decline slightly from the third quarter of fiscal year 2003 as we continue to implement cost reductions and generate other internal efficiencies.

Operating Expenses Sales and Marketing. Sales and marketing expenses were $5,930,000 for the third quarter of fiscal year 2003 and $6,908,000 for the third quarter of fiscal year 2002, representing a decrease of $978,000, or 14 percent. Sales and marketing expenses represented 30 percent of total revenue for the third quarter of fiscal year 2003 down from 45 percent of total revenue for the third quarter of fiscal year 2002. Sales and marketing expenses were $18,421,000 for the first three quarters of fiscal year 2003 and $22,944,000 for the first three quarters of fiscal year 2002, representing a decrease of $4,523,000, or 20 percent. Sales and marketing expenses represented 34 percent of total revenue for the first three quarters of fiscal year 2003 as compared to 47 percent of total revenue for the first three quarters of fiscal year 2002.

The decrease in the dollar amount of sales and marketing expense in the third quarter and for the first three quarters of fiscal year 2003 compared to the third quarter and for the first three quarters of fiscal year 2002 was attributable to fewer sales and marketing employees, reduced travel expenses, fewer commissions and lower co-operative advertising costs as a result of lower revenue, and reduced communication costs. We expect our sales and marketing expenses for the last quarter of fiscal year 2003 will decrease slightly compared to the costs incurred in the third quarter of fiscal year 2003.

Research and Development. Research and development expenses were $2,950,000 for the third quarter of fiscal year 2003 and $4,284,000 for the third quarter of fiscal year 2002, representing a decrease of $1,334,000, or 31 percent. Research and development costs represented 15 percent of total revenue for the third quarter of fiscal year 2003 as compared to 28 percent of total revenue for the third quarter of fiscal year 2002. Research and development expenses were $8,142,000 for the first three quarters of fiscal year 2003 and $13,810,000 for the first three quarters of fiscal year 2002, representing a decrease of $5,668,000, or 41 percent. Research and development costs represented 15 percent of total revenue for the first three quarters of fiscal year 2003 and 28 percent of total revenue for the first three quarters of fiscal year 2002.

The decrease in the dollar amount of research and development expenses in the third quarter and the first three quarters of fiscal year 2003 compared to the third quarter and the first three quarters of fiscal year 2002 was attributable to fewer employees, and reduced outside consulting and contract services. These cost reductions were driven by consolidating development efforts on core engineering projects related to our UNIX operating systems. For the last quarter of fiscal year 2003, we anticipate that our research and development expenses will slightly increase compared to the costs incurred in the third quarter of fiscal year 2003 as we will begin investing additional resources in our UNIX-based operating systems, OpenServer and UnixWare, and our web services initiative, SCOx.

General and Administrative. General and administrative expenses were $1,413,000 for the third quarter of fiscal year 2003 and $2,260,000 for the third quarter of fiscal year 2002, representing a decrease of $847,000, or 37 percent. General and administrative expenses represented 7 percent of total revenue for the third quarter of fiscal year 2003 and 15 percent of total revenue for the third quarter of fiscal year 2002. General and administrative expenses were $4,525,000 for the first three quarters of fiscal year 2003 and $7,394,000 for the first three quarters of fiscal year 2002, representing a decrease of $2,869,000, or 39 percent. General and administrative expenses represented 8 percent of total revenue for the first three quarters of fiscal year 2003 and 15 percent of total revenue for the first three quarters of fiscal year 2002.

The decrease in general and administrative expenses in the third quarter and the first three quarters of fiscal year 2003 compared to the third quarter and the first three quarters of fiscal year 2002 was primarily attributable to fewer employees, and reduced costs for external professional services. We expect general and administrative expenses for the last quarter of fiscal year 2003 will remain consistent with the costs incurred in the third quarter of fiscal year 2003.

Restructuring Charges. During the third quarter of fiscal year 2003, we recorded a restructuring charge of $614,000. The restructuring charge for the third quarter of fiscal year 2003 was comprised entirely of severance and related payments incurred from terminating approximately 35 employees. During the third quarter of fiscal year 2002, we recorded a restructuring charge of $1,245,000. The restructuring charge for the third quarter of fiscal year 2002 was comprised of termination payments made to employees in connection with a reduction in headcount and the elimination of non-essential facilities totaling $2,800,000, offset by a $1,555,000 adjustment from a successful lease renegotiation on one of our facilities that had been vacated in connection with a previous corporate restructuring.

During the first three quarters of fiscal year 2003, we recorded restructuring charges of $498,000, and for the first three quarters of fiscal year 2002, we recorded restructuring charges of $5,581,000. The restructuring charges for the first three quarters of fiscal 2003 were comprised primarily of severance payments to terminated employees and adjustments to previously recorded amounts and the restructuring charges for the first three quarters of fiscal 2002 were comprised primarily of severance payments to terminated employees, the elimination of non-essential facilities, and an adjustment for a successful lease renegotiation.

Amortization of Intangibles. We recorded $895,000 for the amortization of intangibles in the third quarter of fiscal year 2003 and $701,000 in amortization during the third quarter of fiscal year 2002. We recorded $2,295,000 for the amortization of intangibles for the first three quarters of fiscal year 2003 and $2,152,000 in amortization during the first three quarters of fiscal year 2002. This amortization expense is for intangible assets we acquired in connection with the acquisition of technology and other assets from third parties. The increase in the amortization expense is the result of our acquisition of certain assets from Vultus, Inc. during the three months ended July 31, 2003.

Write-down of Investment. During the third quarter and the first three quarters of fiscal year 2003, we did not have any write-down of investments. During the first three quarters of fiscal year 2002, we determined that the current carrying value of our investment in Lineo, Inc. would not be realized and a write-down was necessary. We recorded a write-down of $1,180,000 related to this investment.

Stock-based Compensation (Benefit). In connection with stock options and restricted shares granted to employees and others, we recorded stock-based compensation of $309,000 in the third quarter of fiscal year 2003 and a benefit of ($89,000) for the third quarter of fiscal year 2002. We recorded stock-based compensation of $927,000 for the first three quarters of fiscal year 2003 and $528,000 for the first three quarters of fiscal year 2002.

The increase in stock-based compensation in the third quarter and first three quarters of fiscal year 2003 is primarily attributable to restricted stock grants, whereby the fair value of the restricted stock awards is recorded as a component of stock-based compensation as the restrictions lapse. We also issued a warrant to a consultant which increased our stock-based compensation in the 2003 periods.

Equity in Loss of Affiliate The equity in loss of affiliate relates to our investment in Vista.com ("Vista"), which is accounted for under the equity method of accounting for investments. Under the equity method, we recognize our portion of the net income or net loss of Vista in our consolidated statements of operations. During the third quarter of fiscal year 2003, we recognized a loss of $71,000 that represented our portion of Vista's net loss. For the first three quarters of fiscal year 2003, we recognized a loss of $171,000 that represented our portion of Vista's net loss. We did not have an investment in Vista during the comparable fiscal year 2002 periods.

Other Income (Expense), net Other income (expense), net, which consists principally of interest expense, interest income and other income, was a net expense of $55,000 for the third quarter of fiscal year 2003 and for the third quarter of fiscal year 2002, and a net expense of $59,000 for the first three quarters of fiscal year 2003 and $120,000 for the first three quarters of fiscal year 2002.

Provision for Income Taxes The provision for income taxes was $188,000 for the third quarter of fiscal year 2003 and $214,000 for the third quarter of fiscal year 2002. The provision for income taxes was $495,000 for the first three quarters of fiscal year 2003 and $431,000 for the first three quarters of fiscal year 2002. The provision for the third quarter of fiscal year 2003 related entirely to earnings of our foreign subsidiaries. The provision for income taxes for the first three quarters of fiscal year 2003 was primarily related to earnings of foreign subsidiaries as well as federal alternative minimum tax in the U.S. and state income taxes for states in which we do not have sufficient net operating loss carry forwards to offset current earnings. Our U.S. federal income tax provision for the first three quarters of fiscal year 2003 has been offset with the utilization of net operating loss carry forwards.

Since inception, we have funded our operations primarily through loans from our major stockholder and through sales of common and preferred stock. During the nine months ended July 31, 2003, our operations produced positive cash flow. We believe that we will have sufficient financial resources to fund our current operations for at least the next twelve months, however, if our cash reserves, cash from operations and existing unused line of credit are insufficient to meet our needs, we may not be able to execute our business plan and our operations may be adversely impacted.

As of July 31, 2003, we had cash and cash equivalents of $14,661,000 and working capital of $6,007,000, which includes current liabilities of $6,822,000 for deferred revenue that will not require dollar for dollar of cash to settle, but will be recognized as revenue in future periods. Our total cash and cash equivalents has increased by $8,072,000 from October 31, 2002. This increase resulted primarily from cash provided by SCOsource licensing revenue. Additionally, we have a $2,910,000 line of credit with a commercial bank that bears interest at the prime rate minus one percent (with a floor rate of 3.75 percent) that matures on October 31, 2003. Borrowings under the line of credit are secured by a letter of credit from our principal stockholder. As of July 31, 2003, there were no borrowings outstanding under the line of credit.

Our net cash provided by operations during the nine months ended July 31, 2003 was $7,442,000. Cash provided by operations was primarily attributable to net income of $6,872,000. Non-cash expenses totaled $4,555,000 and cash used by changes in operating assets and liabilities was $3,985,000. Our working capital position increased from a deficit of $6,332,000 as of October 31, 2002 to a positive $6,007,000 as of July 31, 2003, and our long-term liabilities have decreased from $1,625,000 to $611,000 during that same period.

Our investing activities have historically consisted of equipment purchases, investing in strategic partners and the purchase and sale of available-for-sale securities. During the nine months ended July 31, 2003, cash used in investing activities was $2,140,000, which was primarily a result of equipment purchases of $524,000, our investment in affiliated entities of $950,000 and cash paid to wind down our United Kingdom subsidiary of $666,000.

Our financing activities provided $2,329,000 during the nine months ended July 31, 2003 and consisted of proceeds received from the exercise of stock options of $1,443,000, proceeds from the purchase of shares of common stock by our employees through our employee stock purchase program of $236,000 and proceeds from the issuance of warrants of $650,000.

Our net accounts receivable balance decreased from $8,622,000 as of October 31, 2002 to $7,398,000 as of July 31, 2003. The allowance for doubtful accounts was $138,000 as of July 31, 2003, which represented approximately 2 percent of our gross accounts receivable balance. Our write-offs of uncollectible accounts have not been significant.

On June 6, 2003, we acquired substantially all the assets of Vultus, Inc. ("Vultus"), a corporation engaged in the web services interface business. We issued 305,274 shares of our restricted common stock and assumed liabilities of approximately $215,000 in connection with this acquisition. We extended employment offers to most of the Vultus employees, and as a result, will have increased research and development costs in future periods.

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 2008. In recent corporate restructuring activities, we have partially vacated some of these facilities, but still have contractual obligations to continue to make ongoing lease payments that will use available cash. We have pursued and will continue to pursue sublease opportunities, as available, to minimize this use of cash; however, we can not assure that we will be successful in eliminating or reducing cash expenditures for these leases.

The following table summarizes our contractual lease obligations as of July 31, 2003 (in thousands):

Less than one year $ 1,197 One to three years 5,084 Three or more years 845 Total payments $ 7,126

CRITICAL ACCOUNTING POLICIES Our critical accounting policies and estimates include the following: • Revenue recognition; Income taxes and related valuation allowances; • Impairment of long-lived assets; and Allowances for doubtful accounts and product returns.

In each of these areas, management makes estimates based on historical results, current trends and future projections.

Revenue Recognition We recognize revenue in accordance with Statement of Accounting Position ("SOP") 97-2, as amended, and Staff Accounting Bulletin ("SAB") 101. Revenue recognition in accordance with these pronouncements can be complex due to the nature and variability of our sales transactions. We recognize product revenue upon shipment if a signed contract exists, the fee is fixed and determinable, collection of the resulting receivable is probable and product returns are reasonably estimable, except for sales to distributors, which are recognized upon sale by the distributor to resellers or end users. For contracts involving multiple elements (i.e. delivered and undelivered products, maintenance and other services), we allocate revenue to each component of the contract based on objective evidence of its fair value, which is specific to us. The fair value of each element is based on amounts charged when such elements are sold separately. We recognize revenue allocated to undelivered products when the criteria for revenue recognition set forth above have been met.

Our SCOsource licensing revenue to date has been generated from license agreements that are non-exclusive, perpetual, paid up licenses to utilize our UNIX source code. We recognize revenue from licensing agreements when a signed contract exists, the fee is fixed and determinable, collection of the receivable is probable and delivery has occurred. If the payment terms extend beyond our normal payment terms, revenue is recognized as the payments become due.

We recognize revenue from maintenance fees for ongoing customer support and product updates ratably over the period of the maintenance contract. Payments for maintenance fees are generally made in advance and are non-refundable. For revenue allocated to education and consulting services or derived from the separate sale of such services, we recognize revenue as the related services are performed. We recognize product revenue from royalty payments upon receipt of quarterly royalty reports from OEMs related to their product sales.

We have provided a valuation allowance of $48,644,000 against our entire net deferred tax asset as of October 31, 2002. The valuation allowance was recorded because of our history of net operating losses and the uncertainties regarding our future operating profitability and taxable income. Had different assumptions been used regarding the valuation allowance and our net deferred tax asset, our income tax provision could have been materially different than that reported.

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 a valuation of our intangible assets as of October 31, 2002 in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets" and determined that the intangible assets reported in the accompanying consolidated balance sheets are not impaired. Write-downs of intangible assets may be necessary if the future fair value of these assets is less than carrying value.

We offer credit terms on the sale of our products to a significant 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 receivable based upon our historical collection experience and expected collectibility of all accounts receivable. We also maintain an allowance for estimated returns based on our historical experience. Our actual bad debts and returns may differ from our estimates and the differences may be material.

In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others",an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect on the Company's financial statements. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation – Transition and Disclosure", an amendment of FASB Statement No. 123. This Statement amends FASB Statement No. 123, "Accounting for Stock-Based Compensation", to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002.

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51". This Interpretation addresses the consolidation by business enterprises of variable interest entities created after January 31, 2003 and to variable interests in variable interest entities obtains after January 31, 2003. The application of this Interpretation is not expected to have a material effect on the Company's financial statements. The Interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that the Company will consolidate or disclose information about variable interest entities when the Interpretation becomes effective.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Financial instruments within the scope of SFAS No. 150 will be classified as liabilities and measured at fair value. Many of those instruments were previously classified as equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 is not expected to have an impact on our financial position or results of operations.

Form 10-Q

You left out one of the more interesting parts.

(11) SIGNIFICANT CUSTOMERS

During the three months ended July 31, 2003, Microsoft Corporation (“Microsoft”) accounted for approximately 25 percent of total revenue and Sun Microsystems, Inc. (‘Sun”) accounted for approximately 12 percent of total revenue. During the nine months ended July 31, 2003, Microsoft accounted for approximately 16 percent of total revenue and Sun accounted for approximately 12 percent, of total revenue.

Here is a company whose alleged "business" is selling an aging UNIX variant through a reseller channel. Yet its top two customers are Microsoft and Sun.

While many have noticed that SCO's current anti-linux activities benefit Microsoft and Sun far more than they benefit SCO or its customers, and others have speculated that Microsoft and/or Sun were operating secretly behind the stage, no one could prove such a thing.

Now we can.

In addition to these rather obvious transactions, we also know that a venture capital firm in which a Mr. William Gates is a significant investor has quietly passed the 5% ownership level in SCO, triggering a report to the SEC to that effect. These SCO shares were not purchased in the market, but in the form of private placements of newly-issued shares direct from SCO.

Mr. Gates is both corporately and personally shoveling cash into SCO, while that company engages in activities which are quite beneficial to Microsoft, but almost guaranteed to destroy SCO. Other shareholders in SCO are going to have a Hell of a lawsuit when this is over.

We are going to have some interesting times as this unfolds.

Gates is creepy. This isn't even business; this is thuggery. No wonder all his minions act like thugs. The whole corporation is a thug.

If your little trenchcoat man is supposedly an expert on thugs, would this obviously not be the comment of one?

"If somebody sues you, you change the algorithm or you just hire a hit-man to whack the stupid git."

http://groups.google.com/groups?q=g:thl541224082d&dq=&hl=en&lr=&ie=UTF-8&oe=UTF-8&selm=linux.kernel.Pine.LNX.4.44.0208111553010.1233-100000%40home.transmeta.com

Sure sounds like one to me. Especially if he's a foreigner talking about American businessmen.

Okay, First it looks like we will have to start with the usual.

From the Free Republic posting policy:

NO personal attacks!!!

Quiet you!

Secondly if a company over issues its own stock in order to do "legal" dirty dealing or to get around the law in some other way it is COUNTERFEITING IT in my book.

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CSBITA!!!

NO personal attacks!!!

Quiet you!