This is GrokLaw Story 2007031707004564

SCO's 10Q
Saturday, March 17 2007 @ 01:42 PM EDT

Here's SCO's 10Q for the quarterly period ended January 31, 2007. What stands out the most is that SCO says that it believes it has "sufficient liquidity resources" to fund its operations through October of *this* year.

That's all? Then what happens?

So do they actually have enough funds to make it to trial? After all, the Novell litigation goes first and is currently set to begin on September 17, 2007. There is currently no date set for the IBM litigation to even go to trial, but we do know it is expected to last for about 5 weeks. If Novell starts on September 17 and runs for even half that long, oops. Insufficient liquidity resources, I'm thinking, to make it to trial with IBM after that. No wonder SCO asked the court to have IBM go first. That's if either case ever does go to trial. SCO again admits neither may ever make it to a jury.

I'm no math whiz, but doesn't it look to you like SCO needs some more money to finish the litigation it started? Unless it mentions October because that is the end of its fiscal year, and it is being mysterious about after that? Either way, SCO is running low. O, PIPE Fairy, PIPE Fairy, wherefor art thou, PIPE Fairy? -- PIPE Fairy's Auntie? -- Too busy with patent agreements and such?

And that's if Novell doesn't shut it down first. SCO hinted a denial that bankruptcy is imminent and inevitable, as Novell charged in one of its filings. Darl said that isn't what keeps him up at night, remember? Maybe it should, dude. SCO says this about Novell's Motion for a Preliminary Injunction and Partial Summary Judgment, the give-us-our-money motion:

Novell has moved for a preliminary injunction and partial summary judgment. The Company has opposed these filings and filed a cross-motion for partial summary judgment. Those motions were argued on January 23, 2007, before the District Court in Utah. If Novell prevails on these motions, some or all of the Company’s cash and cash equivalents could be encumbered.

Could be, indeed. Here's what it told the court [PDF], though, in opposing Novell's motion, on page 29:

The preliminary injunction Novell seeks would likely preclude SCO from sustaining its operation.

That sounds worse, don't you think? Somehow that sentence didn't make it into the 10Q. So when you read that SCO's finances are improving, one has to ask, in what practical sense? And this is the first time I recall SCO mentioning the possibility of losing its listing on Nasdaq:

We could lose our listing on the Nasdaq Capital Market if our stock price falls below $1.00 for 30 consecutive business days, and the loss of the listing would make our stock significantly less liquid and would affect its value.

Our common stock is listed on the Nasdaq Capital Market and had a closing price of $0.96 at the close of the market on March 14, 2007. If the price of our common stock falls below $1.00 and for 30 consecutive business days remains below $1.00, we will receive a deficiency notice from NASDAQ advising us that we have been afforded a 180-calendar day compliance period. If our stock fails to maintain a minimum bid price of $1.00 for 10 consecutive business days during a 180-day compliance period on the Nasdaq Capital Market or a 360-day grace period if compliance with certain core listing standards are demonstrated, we could receive a delisting notice from the Nasdaq Capital Market, and, under certain circumstances, even if our stock maintains a minimum bid price of $1.00 for 10 consecutive business days, we may receive a delisting notice from the Nasdaq Capital Market. Upon delisting from the Nasdaq Capital Market, our stock would be traded over-the-counter, more commonly known as OTC. OTC transactions involve risks in addition to those associated with transactions in securities traded on the Nasdaq Capital Market. Many OTC stocks trade less frequently and in smaller volumes than securities traded on the Nasdaq Capital Market. Accordingly, our stock would be less liquid than it would otherwise be, and the value of our stock could decrease.

And I can't help but notice this:

Revenue from our SCOsource business decreased slightly from $30,000 for the three months ended January 31, 2006 to $23,000 for the three months ended January 31, 2007. Revenue in the above mentioned periods was primarily attributable to sales of our SCOsource IP agreements.

What I draw from that is an admission that SCO continues to be guilty of violating the GPL into January of this year, at least, making it quite logical for IBM to tell the court that it needs an injunction to make SCO cease and desist.

Here is the meat of the 10Q. You can follow the link, above, to read every word. I've marked in red the parts that stand out as significant to me. You'll likely notice other parts, depending on your fields of expertise:

*********************************

THE SCO GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
January 31, October 31,
2007 2006
ASSETS
CURRENT ASSETS:
Cash and cash equivalents
 $ 7,137 $ 5,369
Restricted cash
 4,498 8,024
Available-for-sale marketable securities
 500 2,249
Accounts receivable, net of allowance for doubtful accounts of $79 and $106, respectively
 4,010 5,123
Other
 1,332 1,514
Total current assets
 17,477 22,279
PROPERTY AND EQUIPMENT:
Computer and office equipment
 2,221 2,259
Leasehold improvements
 262 316
Furniture and fixtures
 78 78
2,561 2,653
Less accumulated depreciation and amortization
 (2,042 ) (2,045 )
Net property and equipment
 519 608
OTHER ASSETS:
 431 522
Total assets
 $ 18,427 $ 23,409
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable
 $ 1,659 $ 2,338
Payable to Novell, Inc.
 519 2,978
Accrued payroll and benefits
 1,792 2,507
Accrued liabilities
 2,685 3,059
Deferred revenue
 2,681 2,994
Royalties payable
 322 439
Income taxes payable
 786 820
Total current liabilities
 10,444 15,135
LONG-TERM LIABILITIES
 191 192
COMMITMENTS AND CONTINGENCIES (Note 3)
STOCKHOLDERS’ EQUITY:
Common stock, $0.001 par value; 45,000 shares authorized, 21,531 and 21,391 shares outstanding, respectively
 22 21
Additional paid-in capital
 260,968 260,259
Common stock held in treasury, 297 shares
 (2,446 ) (2,446 )
Warrants outstanding
 856 856
Accumulated other comprehensive income
 956 932
Accumulated deficit
 (252,564 ) (251,540 )
Total stockholders’ equity
 7,792 8,082
Total liabilities and stockholders’ equity
 $ 18,427 $ 23,409
See accompanying notes to condensed consolidated financial statements.

- 3 -

THE SCO GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(in thousands, except per share data)
Three Months Ended January 31,
2007 2006
REVENUE:
Products
 $ 4,866 $ 6,000
SCOsource licensing
 23 30
Services
 1,126 1,313
Total revenue
 6,015 7,343
COST OF REVENUE:
Products
 377 584
SCOsource licensing
 654 4,010
Services
 559 637
Total cost of revenue
 1,590 5,231
GROSS MARGIN
 4,425 2,112
OPERATING EXPENSES:
Sales and marketing
 2,440 2,688
Research and development
 1,759 1,871
General and administrative
 1,323 1,592
Amortization of intangibles
 — 592
Total operating expenses
 5,522 6,743
LOSS FROM OPERATIONS
 (1,097 ) (4,631 )
EQUITY IN INCOME (LOSS) OF AFFILIATE
 42 (8 )
OTHER INCOME (EXPENSE):
Interest income
 114 152
Other income (expense), net
 29 (7 )
Total other income, net
 143 145
LOSS BEFORE PROVISION FOR INCOME TAXES
 (912 ) (4,494 )
PROVISION FOR INCOME TAXES
 (112 ) (87 )
NET LOSS
 $ (1,024 ) $ (4,581 )
BASIC AND DILUTED NET LOSS PER COMMON SHARE
 $ (0.05 ) $ (0.23 )
WEIGHTED AVERAGE BASIC AND DILUTED COMMON SHARES OUTSTANDING
 21,186 20,062
OTHER COMPREHENSIVE LOSS:
Net loss
 $ (1,024 ) $ (4,581 )
Foreign currency translation adjustment
 24 (6 )
Unrealized loss on available-for-sale marketable securities
 — 34
COMPREHENSIVE LOSS
 $ (1,000 ) $ (4,553 )
See accompanying notes to condensed consolidated financial statements.

- 4 -

THE SCO GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Three Months Ended January 31,
2007 2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss
 $ (1,024 ) $ (4,581 )
Adjustments to reconcile net loss to net cash used in operating activities:
Stock-based compensation
 476 401
Depreciation and amortization
 88 79
Loss on disposition and write-downs of long-lived assets
 20 5
Equity in (income) loss of affiliate
 (42 ) 8
Amortization of intangibles (including $0 and $85 classified as cost of SCOsource licensing revenue)
 — 677
Changes in operating assets and liabilities:
Restricted cash
 1,067 1,117
Accounts receivable, net
 1,113 1,426
Other current assets
 315 303
Accounts payable
 (679 ) 44
Accrued payroll and benefits
 (715 ) (820 )
Accrued liabilities
 (374 ) 248
Deferred revenue
 (313 ) (204 )
Royalties payable
 (117 ) (16 )
Income taxes payable
 (34 ) (63 )
Long-term liabilities
 (1 ) (3 )
Net cash used in operating activities
 (220 ) (1,379 )
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment
 (22 ) (69 )
Purchase of available-for-sale marketable securities
 — (1,031 )
Proceeds from sale of available-for-sale marketable securities
 1,749 —
Net cash provided by (used in) investing activities
 1,727 (1,100 )
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sale of common stock through employee stock purchase program
 230 301
Proceeds from exercise of common stock options
 4 23
Repurchase of common stock
 — (32 )
Proceeds from sale of common stock in a private placement, net of issuance costs
 — 9,905
Net cash provided by financing activities
 234 10,197
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
 1,741 7,718
EFFECT OF FOREIGN EXCHANGE RATES ON CASH
 27 28
CASH AND CASH EQUIVALENTS, beginning of period
 5,369 4,272
CASH AND CASH EQUIVALENTS, end of period
 $ 7,137 $ 12,018
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for income taxes
 $ 103 $ 125
SUPPLEMENTAL SCHEDULE OF NONCASH FINANCING ACTIVITIES:
Decrease in common stock subject to rescission
 $ — $ (1,018 )
See accompanying notes to condensed consolidated financial statements.

- 5 -

THE SCO GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) ORGANIZATION AND DESCRIPTION OF BUSINESS
The business of The SCO Group, Inc. (the “Company”) focuses on marketing reliable, cost-effective UNIX software products and related services for the small-to-medium sized business market, including replicated site franchises of Fortune 1000 companies. The Company has operations in a number of countries that provide support services to customers and resellers. During the year ended October 31, 2003, the Company initiated its SCOsource business to protect and defend its UNIX intellectual property rights. The Company acquired certain intellectual property rights surrounding UNIX and UNIX System V source code in May 2001 from The Santa Cruz Operation, which changed its name to Tarantella, Inc., and was subsequently acquired by Sun Microsystems.
The Company incurred a net loss of $1,024,000 for the three months ended January 31, 2007, and during that same period used cash of $220,000 in its operating activities. As of January 31, 2007, the Company had a total of $7,137,000 in cash and cash equivalents, $500,000 in available-for-sale marketable securities, and $4,498,000 in restricted cash, of which $3,979,000 is designated to pay for experts, consultants and other expenses in connection with the litigation between the Company and IBM, Novell and Red Hat (the “SCO Litigation”), and the remaining $519,000 of restricted cash is payable to Novell for its retained binary royalty stream.
(2) SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of the Company have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) on a basis consistent with the Company’s audited annual financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial information set forth therein. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to SEC rules and regulations, although the Company believes that the following disclosures, when read in conjunction with the audited annual financial statements and the notes thereto included in the Company’s most recent annual report on Form 10-K, are adequate to make the information presented not misleading. Operating results for the three months ended January 31, 2007 are not necessarily indicative of the operating results that may be expected for the year ending October 31, 2007.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from these estimates. The Company’s critical accounting policies and estimates include: revenue recognition, allowances for doubtful accounts

- 6 -

receivable, impairment and useful lives of long-lived assets, litigation reserves, and valuation allowances against deferred income tax assets.
Revenue Recognition
The Company recognizes revenue in accordance with Statement of Position (“SOP”) 97-2, as modified by SOP 98-9. The Company’s revenue has historically been from three sources: (i) product license revenue, primarily from product sales to resellers, end users and original equipment manufacturers (“OEMs”); (ii) technical support service revenue, primarily from providing technical support and consulting services to end users; and (iii) revenue from SCOsource licensing.
The Company recognizes product revenue upon shipment if a signed contract exists, the fee is fixed or determinable, collection of the resulting receivable is probable and product returns are reasonably estimable.
The majority of the Company’s revenue transactions relate to product-only sales. On occasion, the Company has revenue transactions that have multiple elements (such as software products, maintenance, technical support services, and other services). For software agreements that have multiple elements, the Company allocates revenue to each component of the contract based on the relative fair value of the elements. The fair value of each element is based on vendor specific objective evidence (”VSOE”). VSOE is established when such elements are sold separately. The Company recognizes revenue when the criteria for product revenue recognition set forth above have been met. If VSOE of all undelivered elements exists, but VSOE does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the license fee is recognized as revenue in the period when persuasive evidence of an arrangement is obtained assuming all other revenue recognition criteria are met.
The Company recognizes product revenue from OEMs when the software is sold by the OEM to an end-user customer. Revenue from technical support services and consulting services is recognized as the related services are performed. Revenue for maintenance is recognized ratably over the maintenance period.
The Company considers an arrangement with payment terms longer than the Company’s normal business practice not to be fixed or determinable and revenue is recognized when the fee becomes due. The Company typically provides stock rotation rights for sales made through its distribution channel and sales to distributors are recognized upon shipment by the distributor to end users. For direct sales not through the Company’s distribution channel, sales are typically non-refundable and non-cancelable. The Company estimates its product returns based on historical experience and maintains an allowance for estimated returns, which is recorded as a reduction to accounts receivable and revenue.
The Company’s SCOsource revenue to date has been primarily generated from agreements to utilize the Company’s UNIX source code as well as from intellectual property agreements. The Company recognizes revenue from SCOsource agreements when a signed contract exists, the fee is fixed or determinable, collection of the receivable is probable and delivery has occurred. If the payment terms extend beyond the Company’s normal payment terms, revenue is recognized as the payments become due.
Cash and Cash Equivalents
The Company considers all investments purchased with original maturities of three or fewer months to be cash equivalents. Cash equivalents were $4,480,000 and $2,555,000 as of

- 7 -

January 31, 2007 and October 31, 2006, respectively. Cash was $2,657,000 and $2,814,000 as of January 31, 2007 and October 31, 2006, respectively. The Company has $100,000 of cash that is federally insured. All remaining amounts of cash and cash equivalents as well as restricted cash exceed federally insured limits.
Available-for-Sale Marketable Securities
Available-for-sale marketable securities are recorded at fair market value, based on quoted market prices, and unrealized gains and losses are recorded as a component of comprehensive loss. Realized gains and losses, which are calculated based on the specific-identification method, are recorded in operations as incurred.
Available-for-sale marketable securities totaled $500,000 as of January 31, 2007. Available-for-sale marketable securities in an unrealized loss position as of January 31, 2007 were not impaired at acquisition and the decline in fair value is primarily attributable to interest rate fluctuations. A decline in the market value of any available-for-sale marketable security below cost that is deemed other than temporary results in a charge to the statement of operations and establishes a new basis for the security.
Net Loss Per Common Share
Basic net income or loss per common share (“Basic EPS”) is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted net income or loss per common share (“Diluted EPS”) is computed by dividing net loss by the sum of the weighted average number of common shares outstanding and the dilutive potential common share equivalents then outstanding. Potential common share equivalents consist of the weighted average number of shares issuable upon the exercise of outstanding stock options and warrants to acquire common stock. If dilutive, the Company computes Diluted EPS using the treasury stock method.
Due to the fact that for all periods presented the Company has incurred net losses, common share equivalents of 5,604,000 and 4,874,000 for the three months ended January 31, 2007 and 2006, respectively, are not included in the calculation of diluted net loss per common share because they are anti-dilutive.
(3) COMMITMENTS AND CONTINGENCIES
Litigation
IBM Corporation
On or about March 6, 2003, the Company filed a civil complaint against IBM. The case 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. In this action, the Company claims that IBM breached its UNIX source code licenses (both the IBM and Sequent Computer Systems, Inc. (“Sequent”) licenses) by disclosing restricted information concerning the UNIX source code and derivative works and related information
On or about March 6, 2003, the Company notified IBM that IBM was not in compliance with the Company’s UNIX source code license agreement and on or about June 13, 2003, the Company delivered to IBM a notice of termination of that agreement, which underlies IBM’s

- 8 -

AIX software. On or about August 11, 2003, the Company sent a similar notice terminating the Sequent source code license. IBM disputes the Company’s right to terminate those licenses. In the event the Company’s termination of those licenses is valid, the Company believes IBM is exposed to substantial damages and injunctive relief claims based on its continued use and distribution of the AIX operating system. On June 9, 2003, Novell sent the Company a notice purporting to waive the Company’s claims against IBM regarding its license breaches. The Company does not believe that Novell had the right to take any such action relative to the Company’s UNIX source code rights.
On February 27, 2004, the Company filed a second amended complaint which alleges 9 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 14 counterclaims. Among other things, IBM has asserted that the Company does not have the right to terminate IBM’s UNIX license and IBM has claimed that the Company has breached the GNU General Public License and has infringed certain patents held by IBM. IBM’s counterclaims include claims for breach of contract, violation of the Lanham Act, unfair competition, intentional interference with prospective economic relations, unfair and deceptive trade practices, promissory estoppel, patent infringement and a declaratory judgment claim for non-infringement of copyrights. On October 6, 2005, IBM voluntarily dismissed with prejudice its claims for patent infringement.
On December 22, 2005, the Company filed a voluminous report detailing IBM’s misuse of the Company’s proprietary material. The Company’s December 2005 report included 293 total disclosures which the Company claims violate its contractual rights and copyrights. These reports and the disclosures identified are the result of analysis from experienced outside technical consultants.
On February 13, 2006, IBM filed a motion with the court seeking to limit the Company’s claims as set forth in the December 2005 report. IBM argued that of the 293 items the Company had identified, 201 did not meet the level of specificity required by the Court. IBM requested that the Company be limited to 93 items set forth in the December 2005 filing which IBM claims meet the required level of specificity. On June 28, 2006, the Magistrate Judge issued a ruling striking over 180 of the technology disclosures challenged by the Company from the case. This ruling is a limitation of the number of technology disclosures the Company challenged in its December 2005 filing, but means that over 100 of the challenged items remain in the case. On July 13, 2006, the Company filed objections to the Magistrate Judge’s order with the District Court; those objections challenged the process and the result embodied in the Magistrate Judge’s order. On November 29, 2006, the District Court issued a ruling sustaining in full the Magistrate Judge’s ruling of June 28, 2006. The Company has filed a motion to reconsider this ruling and a motion to amend its technology disclosures of December 2005.
On June 8, 2006, IBM filed a motion to confine the Company’s claims to, and strike allegations in excess of, the final disclosures. In this motion, IBM claims that the Company’s technology expert reports go beyond the disclosures contained in the Company’s December 2005 submission to the Court and that those expert reports should be restricted to that extent. On December 21, 2006, the Magistrate Judge granted IBM’s motion. The Company has filed objections to that order with the District Court.
Both parties have filed expert reports and substantially finished expert discovery. IBM has filed 6 motions for summary judgment that, if granted in whole or in substantial part, could resolve the Company’s claims in IBM’s favor or substantially reduce the Company’s claims. The Company has filed 3 motions for summary judgment. The summary judgment motions were heard by the Court on March 1, 5 and 7, 2007, as scheduled, and the Court took all motions

- 9 -

under advisement and will issue rulings at some point in the future. A trial date will be set pending the outcome of those motions.
Novell, Inc.
On January 20, 2004, the Company filed suit in Utah state court against Novell, Inc. for slander of title seeking relief for its alleged bad faith effort to interfere with the Company’s ownership of copyrights related to the Company’s UNIX source code and derivative works and the Company’s UnixWare product. The case is pending in the United States District Court for the District of Utah under the caption, The SCO Group, Inc. v. Novell, Inc., Civil No. 2:04CV00139. In the lawsuit, the Company requested preliminary and permanent injunctive relief as well as damages. Through these claims, the Company seeks to require Novell to assign to the Company all copyrights that the Company believes Novell has wrongfully registered, to prevent Novell from claiming any ownership interest in those copyrights, and to require Novell to retract or withdraw all representations it has made regarding its purported ownership of those copyrights and UNIX itself.
Novell filed two motions to dismiss claiming, among other things, that Novell’s false statements were not uttered with malice and are privileged under the law. The court denied both of Novell’s motions to dismiss. On July 29, 2005, Novell filed its answer and counterclaims against the Company, asserting counterclaims for the Company’s alleged breaches of the Asset Purchase Agreement between Novell and the Company’s predecessor-in-interest, The Santa Cruz Operation, for slander of title, restitution/unjust enrichment, an accounting related to Novell’s retained binary royalty stream, and for declaratory relief regarding Novell’s alleged rights under the Asset Purchase Agreement. On or about December 30, 2005, the Company filed a motion for leave to amend its complaint to assert additional claims against Novell including copyright infringement, unfair competition and a breach of Novell’s limited license to use the Company’s UNIX code. Novell consented to the Company’s filing of these additional claims.
On or about April 10, 2006, Novell filed a motion to stay the case in Utah pending a request for arbitration that Novell and SuSE Linux, GmbH (“SuSE”) filed on the same date in the International Court of Arbitration in France. Through these proceedings, Novell claims that the Company granted SuSE the right to use its intellectual property through the Company’s participation in the UnitedLinux initiative in 2002 and through its acquisition of SuSE, Novell acquired SuSE’s rights as a member of UnitedLinux. On August 21, 2006, the District Court ordered that portions of claims relating to the SuSE arbitration should be stayed but the other portions of claims in the case should proceed. Trial for the remaining matters has been set for September 2007.
The three-person arbitration panel has been selected for the SuSE arbitration in Switzerland, and that process has commenced. The arbitration has been set for December 2007. The proceedings in early 2007 will determine the scope of the arbitration.
In September 2006, Novell filed an Amended Counterclaim asserting 9 claims for relief including, among other things, claims for slander of title, breach of contract, declaratory relief and claims for an accounting, and for a constructive trust over certain revenue the Company collected from Sun and Microsoft in 2003. Novell has moved for a preliminary injunction and partial summary judgment. The Company has opposed these filings and filed a cross-motion for partial summary judgment. Those motions were argued on January 23, 2007, before the District Court in Utah. If Novell prevails on these motions, some or all of the Company’s cash and cash equivalents could be encumbered. No ruling on the motions has been issued and it is not known when a ruling will be issued.

- 10 -

IPO Class Action Matter
The Company is an issuer defendant in a series of class action lawsuits involving over 300 issuers that have been consolidated under; In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). The consolidated complaint alleges, among other things, certain improprieties regarding the underwriters’ conduct during the Company’s initial public offering and the failure to disclose such conduct in the registration statement in violation of the Securities Act of 1933, as amended. Class standing was certified for all of these cases by the Southern District Court of New York.
The plaintiffs, the issuers and the insurance companies negotiated and executed an agreement to settle the dispute between the plaintiffs and the issuers. While the settlement agreement was awaiting approval by the district court, the court of appeals overturned the class certification on December 5, 2006. It is unlikely a settlement of a class action can remain effective as the class is de-certified. If the decision by the court of appeals is not reversed, the Company does not believe the settlement will stand, and it is possible the lawsuit may fragment into individual actions. At this time, the Company does not know and cannot predict the legal or procedural results of such an action. If the de-certification is reversed, and if thereafter the settlement agreement is approved by the court, and if no cross-claims, counterclaims or third-party claims are later asserted, this action will be dismissed with respect to the Company and its directors. If the settlement agreement is not approved by the court, the matter will continue unless another settlement agreement is reached.
The Company has notified its underwriters and insurance companies of the existence of the claims. Management presently believes, after consultation with legal counsel, that the ultimate outcome of this matter will not have a material adverse effect on the Company’s results of operations or financial position and will not exceed the $200,000 self-insured retention already paid or accrued by the Company.
Red Hat, Inc.
On August 4, 2003, Red Hat, Inc. filed a complaint against the Company. The action is pending in the United States District Court for the District of Delaware under the case caption, Red Hat, Inc. v. The SCO Group, Inc., Civil No. 03-772. Red Hat asserts that the Linux operating system does not infringe on the Company’s UNIX intellectual property rights and seeks a declaratory judgment for non-infringement of copyrights and no misappropriation of trade secrets. In addition, Red Hat claims the Company has engaged in false advertising in violation of the Lanham Act, deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, trade libel and disparagement. On April 6, 2004, the court denied the Company’s motion to dismiss this case; however, the court stayed the case and requested status reports every 90 days regarding the case against IBM. Red Hat filed a motion for reconsideration, which the court denied on March 31, 2005. The Company intends to vigorously defend this action. In the event the stay is lifted and Red Hat is allowed to pursue its claims, the Company will likely assert counterclaims against Red Hat.
Other Matters
In April 2003, the Company’s former Indian distributor filed a claim in India, requesting summary judgment for payment of approximately $1,428,000, and an order that the Company trade in India only through the distributor and/or give a security deposit until the claim is paid. The distributor claims that the Company is responsible to repurchase certain software products and to reimburse the distributor for certain other operating costs. Management does not believe that the Company is responsible to reimburse the distributor for any operating costs and also

- 11 -

believes that the return rights related to any remaining inventory have lapsed. The distributor additionally requested that the Indian courts grant interim relief in the form of attachment of local assets. These requests for interim relief have failed in the court, and discovery has commenced and hearings on the main claims have been held and are ongoing. The Company intends to vigorously defend this action.
Pursuit and defense of the above-mentioned matters will be costly, and management expects the costs for legal fees and related expenses will be substantial. A material, negative impact on the Company’s results of operations or financial position from the Red Hat, Inc., IPO Class Action, or Indian Distributor matters, or the IBM or Novell counterclaims is neither probable nor estimable.
The Company is a party to certain other legal proceedings arising in the ordinary course of business. Management believes, after consultation with legal counsel, that the ultimate outcome of these legal proceedings will not have a material adverse effect on the Company’s results of operations, financial position or liquidity.
(4) STOCKHOLDERS’ EQUITY
Issuance of Common Stock
On November 29, 2005, the Company entered into a Common Stock Purchase Agreement (“Purchase Agreement”) with several institutional investors and one member of the Company’s board of directors. On November 30, 2005, the Company sold to the investors approximately 2,852,000 shares of the Company’s common stock for gross proceeds of approximately $10,005,000. The costs to facilitate the private placement of the common stock were approximately $196,000. The shares issued to the institutional investors were issued at $3.50 per share and the shares issued to the board member were issued at $3.92 per share. Pursuant to the Purchase Agreement, the Company agreed to use its best efforts to file a registration statement with the SEC covering the resale of this common stock, and to use its commercially reasonable efforts to have such registration statement declared effective. On May 25, 2006, this registration statement was declared effective by the SEC.
Equity Plans
The Company has established the 1998 Stock Option Plan (the “1998 Plan”), 1999 Omnibus Stock Incentive Plan (the “1999 Plan”), the 2002 Omnibus Stock Incentive Plan (the “2002 Plan”) and the 2004 Omnibus Stock Incentive Plan (the “2004 Plan”) for the award of stock options, stock appreciation rights, restricted stock, phantom stock rights, and stock bonuses to employees, executive officers, members of the Board of Directors and outside consultants. The Compensation Committee of the Board of Directors has the ability to determine the terms of the option, the exercise price, the number of shares subject to each option, and the exercisability of the options. The Company’s current practice is for the Compensation Committee to recommend option grants subject to the approval and ratification of the entire Board of Directors at regularly scheduled board meetings. Under the terms of the 1998, 1999, 2002 and 2004 Plans, options generally expire 10 years from the date of grant or within 90 days of termination. Options granted under these plans generally vest 25 percent after the completion of one year of service and then 1/36 per month for the remaining three years and become fully vested at the end of four years. Pursuant to the terms of their grant agreements, certain of the options granted under these plans may be subject to accelerated vesting upon a change in control of the Company.
The Company has also established an employee stock purchase plan, which is designed to allow eligible employees of the Company and its participating subsidiaries to purchase shares of the Company’s common stock, at semi-annual intervals, through periodic payroll deductions.

- 12 -

Prior to October 31, 2005, as permitted under Statement of Financial Accounting Standards (“SFAS”) No. 123, the Company accounted for its stock option plans following the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock issued to Employees,” and related interpretations. Accordingly, no stock-based compensation expense had been reflected in the Company’s statements of operations as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant and the related number of shares granted was fixed at that point in time.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), “Share Based Payment.” This statement revised SFAS No. 123 by eliminating the option to account for employee stock options under APB No. 25 and requiring companies to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards.
Effective November 1, 2005, the Company adopted the fair value recognition provisions of SFAS No. 123(R) using the modified prospective application method. Under this transition method, the Company recorded compensation expense on a straight-line basis for the three months ended January 31, 2007 and 2006, for: (a) the vesting of options granted prior to November 1, 2005 (based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and previously presented in the pro-forma footnote disclosures), and (b) stock-based awards granted subsequent to November 1, 2005 (based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R)).
The effect of accounting for stock-based awards under SFAS No. 123(R) for the three months ended January 31, 2007 and 2006 was to record $476,000 and $401,000, respectively, of stock-based compensation expense. For the three months ended January 31, 2007 and 2006, the Company has allocated stock-based compensation expense to the following statement of operations captions:
Three Months Ended January 31,
2007 2006
Cost of products
 $ — $ 2,000
Cost of SCOsource licensing
 70,000 53,000
Cost of services
 3,000 12,000
Sales and marketing
 111,000 68,000
Research and development
 43,000 20,000
General and administrative
 249,000 246,000
Total stock-based compensation
 $ 476,000 $ 401,000
With respect to stock options granted during the three months ended January 31, 2007 and 2006, the assumptions used in the Black-Scholes option-pricing model are as follows:
Three Months Ended January 31,
2007 2006
Risk-free interest rate
 4.8 % 4.4 %
Expected dividend yield
 0.0 % 0.0 %
Volatility
 85.9 % 63.0 %
Expected exercise life (in years)
 5.0 5.0
The estimated fair value of stock options and ESPP shares are amortized over the vesting period of the award.

- 13 -

During the three months ended January 31, 2007, the Company granted options to purchase approximately 869,000 shares of common stock with an average exercise price of $2.30 per share. None of these stock options were granted with an exercise price below the quoted market price on the date of grant. During the three months ended January 31, 2007, options to purchase approximately 5,000 shares of common stock were exercised with an average exercise price of $0.87 per share. As of January 31, 2007, there were approximately 5,369,000 stock options outstanding with a weighted average exercise price of $3.82 per share.
(5) SEGMENT INFORMATION
The Company’s resources are allocated and operating results managed to the operating income (loss) level for each of the Company’s segments: UNIX and SCOsource. Both segments are based on the Company’s UNIX intellectual property. The UNIX business sells and distributes UNIX products and services through an extensive distribution channel and to corporate end-users and the SCOsource business enforces and protects the Company’s UNIX intellectual property. Segment disclosures for the Company are as follows:
Three Months Ended January 31, 2007
UNIX SCOsource Total
Revenue
 $ 5,992,000 $ 23,000 $ 6,015,000
Cost of revenue
 936,000 654,000 1,590,000
Gross margin (deficit)
 5,056,000 (631,000 ) 4,425,000
Sales and marketing
 2,440,000 — 2,440,000
Research and development
 1,759,000 — 1,759,000
General and administrative
 1,323,000 — 1,323,000
Total operating expenses
 5,522,000 — 5,522,000
Loss from operations
 $ (466,000 ) $ (631,000 ) $ (1,097,000 )
Three Months Ended January 31, 2006
UNIX SCOsource Total
Revenue
 $ 7,313,000 $ 30,000 $ 7,343,000
Cost of revenue
 1,221,000 4,010,000 5,231,000
Gross margin (deficit)
 6,092,000 (3,980,000 ) 2,112,000
Sales and marketing
 2,688,000 — 2,688,000
Research and development
 1,777,000 94,000 1,871,000
General and administrative
 1,532,000 60,000 1,592,000
Amortization of intangibles
 592,000 — 592,000
Total operating expenses
 6,589,000 154,000 6,743,000
Loss from operations
 $ (497,000 ) $ (4,134,000 ) $ (4,631,000 )

- 14 -

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Management’s Discussion and Analysis of Financial Condition and Results of Operations and other parts of this quarterly report on Form 10-Q contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can also be identified by words such as “intends,” “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those set forth below under “Forward-Looking Statements and Factors that May Affect Future Results and Financial Condition” and Part II, Item 1A – Risk Factors and elsewhere in this Form 10-Q. The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included in this Form 10-Q and our audited consolidated financial statements included in our annual report on Form 10-K for the year ended October 31, 2006 filed with the Securities and Exchange Commission and management’s discussion and analysis contained therein. All information presented herein is based on the three months ended January 31, 2007 and 2006. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.
Business Focus
UNIX Business. Our UNIX business serves the needs of small-to-medium sized businesses, including replicated site franchisees of Fortune 1000 companies, by providing reliable, cost effective UNIX software technology for distributed, embedded and network-based systems. Our largest source of UNIX business revenue is derived from existing customers through our worldwide, indirect, leveraged channel of partners, which includes distributors and independent solution providers. We have a presence in a number of countries that provide support and services to customers and resellers. The other principal channel for selling and marketing our UNIX products is through existing customers that have a large number of replicated sites or franchisees.
We access these corporations through their information technology or purchasing departments with our Area Sales Managers (“ASMs”) in the United States and through our reseller channel in countries outside the United States. In addition, we also sell our operating system products to original equipment manufacturers (“OEMs”). Our sales of UNIX products and services during the last several years have been primarily to existing UNIX customers and not newly acquired customers. Our UNIX business revenue depends significantly on our ability to market and sell our products to existing customers and to generate upgrades from existing customers.
The following table shows the operating results of the UNIX business for the three months ended January 31, 2007 and 2006:
Three Months Ended January 31,
2007 2006
Revenue
 $ 5,992,000 $ 7,313,000
Cost of revenue
 936,000 1,221,000
Gross margin
 5,056,000 6,092,000
Sales and marketing
 2,440,000 2,688,000
Research and development
 1,759,000 1,777,000
General and administrative
 1,323,000 1,532,000
Amortization of intangibles
 — 592,000
Total operating expenses
 5,522,000 6,589,000
Loss from operations
 $ (466,000 ) $ (497,000 )

- 15 -

Revenue from our UNIX business decreased by $1,321,000, or 18%, for the three months ended January 31, 2007 compared to the three months ended January 31, 2006. The revenue from this business has been declining over the last several years primarily as a result of increased competition from alternative operating systems, particularly Linux. We believe the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX business because users of Linux generally do not pay for the operating system itself, but pay for services and maintenance. The Linux operating system competes directly with our OpenServer and UnixWare products and has taken significant market share from these products.
Operating costs for our UNIX business decreased from $6,589,000 for the three months ended January 31, 2006 to $5,522,000 for the three months ended January 31, 2007. This decrease was primarily attributable to reduced headcount and related costs as well as from the elimination of amortization expense from intangible assets. Our intangible assets became fully amortized during the three months ended October 31, 2006.
The decline in our UNIX business revenue may be accelerated if industry partners withdraw their support for our products. The decline in our UNIX business and our SCOsource business may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products. This would lead to an accelerated decline in revenue and negative cash flows from our UNIX business.
SCOsource Business. During the year ended October 31, 2003, we became aware that our UNIX code and derivative works had been inappropriately included by others in the Linux operating system. We believe the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX business because users of Linux generally do not pay for the operating system itself, but pay for services and maintenance. The Linux operating system competes directly with our OpenServer and UnixWare products and has taken significant market share from these products.
In an effort to protect and defend our UNIX intellectual property rights, we initiated our SCOsource business. We have incurred significant legal costs in an effort to defend and protect our UNIX intellectual property rights and expect that costs and expenses for this business for the year ending October 31, 2007 will be material.
The following table shows the operating results of the SCOsource business for the three months ended January 31, 2007 and 2006:
Three Months Ended January 31,
2007 2006
Revenue
 $ 23,000 $ 30,000
Cost of revenue
 654,000 4,010,000
Gross deficit
 (631,000 ) (3,980,000 )
Research and development
 — 94,000
General and administrative
 — 60,000
Total operating expenses
 — 154,000
Loss from operations
 $ (631,000 ) $ (4,134,000 )
Revenue from our SCOsource business decreased slightly from $30,000 for the three months ended January 31, 2006 to $23,000 for the three months ended January 31, 2007. Revenue in the above mentioned periods was primarily attributable to sales of our SCOsource IP agreements.

- 16 -

Cost of revenue, which primarily includes legal and professional fees incurred in connection with defending our UNIX intellectual property rights in the SCO Litigation, decreased from $4,010,000 for the three months ended January 31, 2006 to $654,000 for the three months ended January 31, 2007. The decrease in cost of revenue was primarily attributable to the absence of the $2,000,000 quarterly payment for Boies, Schiller & Flexner LLP, Kevin McBride and Berger Singerman (the “Law Firms”) (which quarterly payments ended during the three months ended January 31, 2006), and by significant decreases in legal services provided by technical, industry, damage and other experts in connection with the SCO Litigation. In addition to the expenses incurred above, we must also pay one or more contingency fees upon any amount we or our stockholders may receive as a result of a settlement, judgment, or a sale of our company.
Because of the unique and unpredictable nature of the SCO Litigation, the occurrence and timing of certain expenses such as damage, industry and technical review and other consultants is difficult to predict, and it will be difficult to predict the total cost of revenue for the upcoming quarters.
Because of the uncertainties related to our SCOsource business, the success of the SCOsource business depends on the strength of our intellectual property rights and claims regarding UNIX, including our claims against Novell and the strength of our claim that unauthorized UNIX source code and derivative works are contained in Linux.
Critical Accounting Policies