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SCO's 10Q
Thursday, March 18 2004 @ 04:03 PM EST

SCO's most recent 10Q is filed, and as usual, you have to read their filing very carefully. I'll show you what I mean.

LAWSUITS

Here is how they describe the IBM lawsuit, beginning on page 12, and I've marked the salient issues in blue:

"On or about March 6, 2003, we filed a complaint against IBM. This action is currently pending in the United States District Court for the District of Utah, under the title The SCO Group, Inc. vs. International Business Machines Corporation, Civil No. 2:03CV0294. The complaint includes claims for breach of contract, misappropriation of trade secrets, tortious interference, and unfair competition. The complaint also alleges that IBM obtained information concerning the UNIX source code and derivative works from us and inappropriately used and distributed that information in connection with its efforts to promote the Linux operating system.  As a result of IBM’s breach of contract and unfair competition and the marketplace injury sustained by us, we are requesting damages in an amount to be proven at trial, but no less than $1 billion, together with additional damages through and after the time of trial. On or about June 13, 2003, we delivered to IBM a notice of termination of IBM’s UNIX license agreement with us that underlies IBM’s AIX software.

  "On or about June 16, 2003, we filed an amended complaint in the IBM case. The amended complaint essentially restates and re-alleges the allegations of the original complaint and expands on those claims in several ways.  Most importantly, the amended complaint raises new allegations regarding IBM’s actions and breaches through the products and services of Sequent Computer Systems, Inc. (“Sequent”), which IBM acquired.  We allege that IBM breached the Sequent agreement in several ways similar to those set forth above and we seek damages for those breaches.  We are also seeking injunctive relief on several claims.  

  "IBM has filed a response and counterclaim to the complaint, including a demand for a jury trial.  We have filed an answer to the IBM counterclaim denying the claims and asserting affirmative defenses.

  "In its counterclaim, as amended on September 25, 2003, IBM asserts that we do not have the right to terminate its UNIX license or assert claims based on our ownership of UNIX intellectual property against them or others in the Linux community.  In addition, IBM asserts we have breached the GNU General Public License and have infringed certain patents held by IBM. IBM’s counterclaims include claims for breach of contract, violation of the Lanham Act, unfair competition, intentional interference with prospective economic relations, unfair and deceptive trade practices, promissory estoppel, copyright infringement and patent infringement.  Discovery is ongoing in the case. We intend to vigorously defend these counterclaims.

"On February 4, 2004, we filed a motion for leave to file amended pleadings in the case proposing to amend our complaint against IBM and to modify our affirmative defenses against IBM’s counterclaims.  On February 25, 2004, the court granted our motion for leave.  The second amended complaint, which was filed on February 27, 2004, alleges nine causes of action that are similar to those set forth above, adds a new claim for copyright infringement and removes the claim for misappropriation of trade secrets.  IBM has not yet responded to the second amended complaint."

Notice anything missing? How about Novell asserting that it has overruled SCO's "termination" of IBM's AIX license? Think that might be relevant to a shareholder? As for the rest, the positive spin is remarkable. Not a word about the discovery order requiring them to identify the allegedly infringing code prior to receiving AIX, something their lawyer said in open court they are not able to do, and they don't mention that the motion the court "granted" wasn't opposed. If you were not following the case closely, you'd almost think they were winning.

They do mention the Novell matter, but not until page 40:

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

Do you find that an accurate and complete description of what happened, namely that Novell sent SCO letters vetoing SCO's terminations? To me it sounds more like they want you to think that Novell made some public comments and said they had the right to veto but it leaves unclear what, if anything, they actually did about it ("purported to veto").

THE CONVERSION

There is, of course, plenty about the conversion, and again, I have marked in blue the parts that answer the questions I have seen asked most frequently:

"On October 16, 2003, the Company issued 50,000 shares of its redeemable Series A Convertible Preferred Stock (the “Series A”) for $1,000 per share.  The net proceeds from the sale of the Series A were $47,740,000.  The value of the Series A is classified outside of permanent equity because of certain redemption features that are outside the control of the Company.   As described in Note 10, on February 5, 2004, all outstanding Series A shares were exchanged for shares of the Company’s redeemable Series A-1 Convertible Preferred Stock and, as a result, no Series A shares remain outstanding as of February 5, 2004.

  "The terms of the Series A include a number of redemption provisions that represent a derivative financial instrument under SFAS No. 133, 'Accounting for Derivative Instruments and Hedging Activities.'  The Company determined that the conversion feature to allow the holders of the Series A to acquire common shares was an embedded derivative that does not qualify as a scope exemption under the provisions of EITF 00-19, 'Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in a Company’s Own Stock.'  This required the Company to record at fair value and mark-to-market the fair value of the derivative.  Changes in the fair value of the derivative are recorded in the Company’s statement of operations.  As of October 16, 2003, the Company, through the assistance of an independent valuation firm, determined the initial fair value of the derivative was $18,069,000.  As of October 31, 2003, the fair value of the derivative was $15,224,000 and the decrease in fair value of $2,845,000 was recorded as other income in the statement of operations for fiscal year 2003.

  "As of January 31, 2004, the fair value of the derivative was $11,600,000, and the decrease in fair value of $3,624,000 was recorded as other income in the statement of operations for three months ended January 31, 2004.  Assumptions used to value the derivative as of January 31, 2004 included a term of three years, fair value of common stock of $14.37 and an interest rate for similar securities of 15 percent.

  "Dividends will be paid after the first anniversary of the closing and will be paid quarterly at a rate of 8 percent per annum, subject to annual increases of 2 percent per annum, not to exceed     12 percent per annum.  The Company has the option of paying dividends in cash or shares of the Series A, subject to certain limitations.  Because dividends are not payable during the first year the Series A is outstanding, the Company has accrued dividends of $756,000 for three months ended January 31, 2004, which reduced earnings to common stockholders.  These dividends are in addition to $123,000 in accrued dividends recorded in fiscal year 2003.

  "Subject to certain limitations, each holder of the Series A will have the right to convert, at the option of the holder, at any time, into shares of the Company’s common stock at a stated conversion price of $16.93 per share, subject to stock splits, stock dividends or other occurrences.  The Company has the ability to force conversion of the Series A at any time the Company’s common stock price exceeds 150 percent of the then prevailing conversion price per share for 20 consecutive trading days, provided the Company satisfies certain other requirements.

  "The Company was required to file a registration statement on Form S-3 covering the resale of the shares of common stock issuable upon conversion of the Series A.  This registration statement was declared effective by the Securities and Exchange Commission on February 25, 2004. . . .

"In addition to receiving fees at reduced hourly rates, the Company’s agreement with the law firms provides that the law firms will receive a contingency fee of 20 percent of the proceeds from specified events related to the protection of the Company’s intellectual property rights.  These events may include settlements, judgments, licensing fees, subject to certain exceptions, and a sale of the Company during the pendancy of litigation or through settlement, subject to agreed upon credits for amounts received as discounted hourly fees and unused retainer fees.  Additionally, the Company’s agreement with the law firms may also be construed to include contingency fee payments in connection with the Company’s issuance of equity securities.  Future payments payable to the law firms under this arrangement may be significant. . . .

"The holders of shares of redeemable Series A-1 Convertible Preferred Stock have preferential redemption rights and rights upon liquidation that could adversely affect the holders of our common stock.

  On October 16, 2003, we completed a $50,000,000 private placement of 50,000 shares of our redeemable Series A Convertible Preferred Stock and received net proceeds of approximately $47,740,000.  On February 5, 2004, we completed an exchange transaction in which each outstanding share of redeemable Series A Convertible Preferred Stock was exchanged for one share of our new redeemable Series A-1 Convertible Preferred Stock.

"If the holders of shares of redeemable Series A-1 Convertible Preferred Stock choose not to convert their shares, then,  they will be entitled to require us to repurchase for cash all the shares of redeemable Series A-1 Convertible Preferred Stock held by them at a premium price if any of several redemption trigger events occurs.  These redemption provisions, if triggered, would require us to redeem the then-issued and outstanding shares of our redeemable Series A-1 Convertible Preferred Stock for cash.

  "Additionally, the Certificate of Designation for the redeemable Series A-1 Convertible Preferred Stock provides that the number of shares of our common stock issuable upon the conversion of shares of redeemable Series A-1 Convertible Preferred Stock is limited to 2,863,135 shares in the aggregate, notwithstanding that the holders of shares of redeemable Series A-1 Convertible Preferred Stock may otherwise be entitled to receive more shares of common stock upon conversion based on the applicable conversion price. If the number of shares of common stock issuable to the holders of shares of redeemable Series A-1 Convertible Preferred Stock upon conversion is limited in this manner, then we may be required by the holders of such shares to redeem for cash the number of shares of redeemable Series A-1 Convertible Preferred Stock that were not issuable upon conversion as a result of such limits on conversion. If we were required to pay cash to the holders of shares of our redeemable Series A-1 Convertible Preferred Stock for any reason, it could have a material impact on our liquidity, which may require us to obtain additional sources of cash to sustain operations and may negatively impact the holders of our common stock.

  "Further, the holders of shares of our redeemable Series A-1 Convertible Preferred Stock will be entitled to receive a preferential distribution of our assets prior to any distribution to our holders of common stock upon a liquidation, dissolution, winding up or other change in control transaction in which we sell all or substantially all our assets or merge or consolidate or otherwise combine with another company or entity. Upon the occurrence of a liquidation event, the holders of redeemable Series A-1 Convertible Preferred Stock will be entitled to receive the greater of:

  •     the value of the shares of redeemable Series A-1 Convertible Preferred Stock held by them determined by multiplying the closing sale price of our common stock on the Nasdaq SmallCap Market on the date of the liquidation event by the number of shares of common stock into which the preferred shares could be converted at the time of the liquidation event; or      
  •   up to $50,000,000, the aggregate purchase price paid by the investors in our October 2003 redeemable Series A Convertible Preferred Stock private placement, plus eight percent of that amount less the amount of any dividends paid to the preferred stockholders in the calendar year in which the liquidation event occurs.
 

"Depending on the amount of assets we have available for distribution to stockholders upon a liquidation event when shares of redeemable Series A-1 Convertible Preferred Stock remain outstanding, we may be required to distribute all such assets or a portion of such assets that exceeds the preferred stockholders’ pro rata ownership of our common stock assuming full conversion of their preferred shares into common stock, which could eliminate or limit the assets available for distribution to our common stockholders. Our potential obligation to pay to the law firms representing us in our efforts to establish our intellectual property rights a contingent fee of 20 percent of the proceeds we receive from a sale of our company, subject to certain limitations, could also contribute to eliminating or limiting the assets available for distribution to our common stockholders."

CASH FLOWS FROM INVESTING ACTIVITIES

Comparing this quarter with the corresponding quarter of 2003, SCO spent $350,000 investing in "non-marketable securities" in 2003, presumably some kind of investment. They neither bought nor sold any regular stock, which would constitute "available-for-sale securities," I'm told.

In Q1 of 2004, the picture changes radically. No investment in non-marketables, but $4 million spent buying stock, and $1.3 million cash realized selling stock. A net cash drain. It raises the question, what stock was SCO buying and selling that quarter? Remember this is for Q1/04, *before* the buyback.

SCOSOURCE MONIES

It's good to keep clear that their definition of SCOsource includes monies from licenses for UNIX products and services, not just IP compliance licenses. Widespread reports that they realized $20,000 this last quarter from IP compliance licenses are probably accurate, because they had no UNIX license money this quarter, that we know of. The BBC, for example, reported the $20,000 as IP compliance license money: "By contrast SCO has only won $20,000 in licence payments for its disputed intellectual property." We all did, because Robert Bench in the teleconference said that was what it was:

"Our first-quarter revenue was $11.4 million, primarily attributed to our UNIX products and services. Revenue from our SCOsource division relating to compliance licenses was $20,000. Our SCOsource initiatives are continuing as planned, and we expect SCOsource related revenue will gain traction this quarter and continue to increase momentum in future quarters."

But when you look at the 10Q, you notice that the way they define SCOsource, it also means money from Unix licenses, such as the payments from MS and Sun:

"The Company’s SCOsource licensing revenue to date has been generated from license agreements to utilize the Company’s UNIX source code as well as from intellectual property compliance licenses.  The Company recognizes revenue from SCOsource 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 the Company’s normal payment terms, revenue is recognized as the payments are received."

This quarter, so far as we know, there was no UNIX licensing money, so likely it was compliance loot. But with SCO, it's worthwhile to look at every detail carefully.

SIGNIFICANT CUSTOMER - TECH DATA

There is one detail that I can't explain. In section 8, Significant Customers, SCO lists Tech Data as making up about 10% of their income. I wrote to Tech Data but have not received a reply. What I wonder about, since Tech Data has been associated with Caldera since at least 2000, (they did Linux training classes with them), is whether this means they have increased their ties with SCO or whether SCO's income has gone down sufficiently that they now make up 10%. Here is the info from the 10Q:

"(8)   SIGNIFICANT CUSTOMERS

  "During the three months ended January 31, 2004, Tech Data Corporation accounted for approximately 10 percent of total revenue.  During the three months ended January 31, 2003, the Company did not have any customers that accounted for more than 10 percent of total revenue."

Here is how Tech Data describes itself in a press release about a deal they did with Sun:

"About Tech Data

"Tech Data Corporation (NASDAQ/NMS: TECD), founded in 1974, is a leading global provider of IT products, logistics management and other value-added services. Ranked 117th on the Fortune 500, the company and its subsidiaries serve more than 100,000 technology resellers in the United States, Canada, the Caribbean, Latin America, Europe and the Middle East. Tech Data’s extensive service offering includes pre- and post-sale training and technical support, financing options and configuration services as well as a full range of award-winning electronic commerce solutions. The company generated sales of $15.7 billion for its most recent fiscal year, which ended January 31, 2003."

GERMANY

Here is what the 10Q says about Germany, and it doesn't match the Computerwoche report:

"Several entities in Germany have obtained temporary restraining orders in Germany precluding our German subsidiary, from making statements in Germany that, in substance, disparage Linux, or entities involved in the Linux industry, or implicate Linux as infringing our intellectual property rights. SCO GmbH has received an administrative fine of 10,000 Euros for a technical violation of one of the temporary restraining orders. We are currently negotiating with the various claimants in Germany over the temporary restraining orders and our options regarding these matters. Informal complaints similar to those raised in Germany have been received from companies in Austria and Poland. We have responded to those complaints. It is not known if those complainants will take future action."

COMPETITORS

Then there is this funny bit of wordsmithing:

"In the UNIX operating system market, our competitors include IBM, Hewlett-Packard, Sun, Microsoft and Linux distributors."

You wouldn't want to say "Red Hat" here, because the judge in Delaware might read this and get ideas about whether or not certain threats were aimed at certain Linux distributors who really were competitors of SCO.

DEPENDENCE ON DEVELOPERS

There is one sentence in their 10Q that is absolutely true:

DEPENDENCE ON DEVELOPERS

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

If developers, and that means coders, don't like you or your product, they won't work with you or for you, and then what will you do? It's something a company planning to stay in the software business would be expected to consider before attacking the GPL.

REGULATORS

  Finally, there is this prophetic statement:

"In addition to these above-mentioned actions, other regulators or others in the Linux community may initiate legal actions against us, all of which may negatively impact our operations or future operating performance."

It's been hinted in the media that the FTC and the SEC are already investigating. If they are, you'd expect the filing to say so. Since there isn't any word about it, I presume they are now on the record that no such investigations are currently known to them.


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