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SCO Files Its 10Q Sob Story - Updated
Thursday, September 14 2006 @ 04:12 AM EDT

SCO has filed its 10Q for the quarter ending July 31, 2006, and it's a sad story of decline, which it blames squarely on everyone but itself:
Revenue from our UNIX business decreased by $1,931,000, or 21%, for the three months ended July 31, 2006 compared to the three months ended July 31, 2005 and decreased by $5,549,000, or 20%, for the nine months ended July 31, 2006 compared to the nine months ended July 31, 2005. The revenue from this business has been declining over the last several periods primarily as a result of increased competition from alternative operating systems, particularly Linux. We believe the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX business because users of Linux generally do not pay for the operating system itself, but pay for services and maintenance. ...

Our SCOsource revenue for the years ended October 31, 2005 and 2004 was significantly lower than revenue generated during the year ended October 31, 2003, and we believe and allege our revenue and related revenue opportunities have been adversely impacted by Novellā€™s claim of UNIX copyright ownership, which may have caused potential customers to delay or forego licensing with us until an outcome in this legal matter has been reached.

I hate to break the news, but I don't think anyone is foregoing or postponing licensing with SCO. I think they don't plan on doing so ever.

Their tale of woe is compounded by legal expenses, as described in the Risks section, those expenses going up just as their income is going down. It seems they had to fill up the escrow glass again in June and those experts aren't cheap:

On June 5, 2006, we entered into an amendment to the Engagement Agreement and agreed with the Law Firms to deposit an additional $5,000,000 into the escrow account to cover additional expert, consulting and other expenses. In the event that we exhaust these funds, we will continue to pay for expert, consulting and other expenses through the conclusion of our litigation with IBM. As we continue with discovery and other trial preparations, we may be required to place additional amounts into the escrow account, which could harm our liquidity position. As of July 31, 2006, we had a total of $13,960,000 in cash and cash equivalents and available-for-sale marketable securities and an additional $1,561,000 of restricted cash to be used to pursue the SCO Litigation. Since October 31, 2004, we have spent $8,439,000 for expert, consulting and other costs as agreed to in the Engagement Agreement with our legal counsel in the SCO Litigation.

How about that? 8 1/2 million dollars in about two years just for experts and consultants. Let's face it. It has to be hard to get anyone to agree to help you if you are the SCO Group.

I am imagining SCO approaching an expert and asking for help with the litigation. "Could you say that errno.h violates our copyrights or copies our methods and concepts?" And in my imagination I hear the expert snort, "Hah! Maybe for a cool million!" "Done," says SCO, reaching into a suitcase.

Joke, joke. But 8 1/2 million is a lot of money, particularly since it's on top of the $26 million already paid for attorneys' fees. Only a million and a half left in the escrow pot. And no end in sight.

Here's the breakdown:

The Company incurred a net loss of $12,855,000 for the nine months ended July 31, 2006 and during that same period used cash of $7,050,000 in its operating activities. A significant portion of the net loss and the cash used in operating activities was associated with the Company protecting and defending its intellectual property rights. As of July 31, 2006, the Company had a total of $8,861,000 in cash and cash equivalents, $5,099,000 in available-for-sale marketable securities, and $2,010,000 in restricted cash, of which $1,561,000 is designated to pay for experts, consultants and other expenses in the SCO Litigation, and the remaining $449,000 of restricted cash is payable to Novell for its retained binary royalty stream.

The one advantage to making less is they owe Novell less this quarter. Last 10Q it was $3,200,000. Lower income taxes too. So that's the good news.

Here's the 8K filed on June 8, 2006 announcing the amendment to the agreement with Boies Schiller and the gang, otherwise known as "The Three Original Firms", the amendment being titled First Amendment to the Letter Agreement dated October 31, 2004 among The SCO Group, Inc., Boies, Schiller & Flexner LLP, Kevin McBride, and Berger Singerman:

The purpose of the Amendment is to replenish, as necessary, the escrow account (the "Escrow Account"), which is designed to cover the expert, consulting and other expenses of the current litigation between the Company and International Business Machines Corporation, Novell, Inc., Red Hat, Inc., AutoZone, Inc. and Daimler Chrysler, Inc. The Company and BSF mutually agreed, pursuant to the terms of the Amendment, to initially replenish the Escrow Account in the amount of $5 million.

We also get to understand what Darl McBride was talking about in the recent 3Q financials call, when he mentioned troubles with certification:

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

The problem SCO faces is a kind of Catch 22. No one wants to bother with certification or application development efforts for software not many folks are buying. And then because of a lack of certification or applications, fewer will buy. Here's the part about fewer buying:

If the market for UNIX continues to contract, our business will be harmed.

Our revenue from the sale of UNIX products has declined over the last several years. This decrease in revenue has been attributable primarily to increased competition from other operating systems, particularly Linux. Our sales of UNIX products and services are primarily to existing customers. If the demand for UNIX products continues to decline, and we are unable to develop UNIX products and services that successfully address a market demand, our UNIX revenue will continue to decline, industry participants may not certify to our operating system and products, we may not be able to attract new customers or retain existing customers and our business and results of operations will be adversely affected. Because of the long adoption cycle for operating system purchases and the long sales cycle of our operating system products, we may not be able to reverse these revenue declines quickly.

See, if you put almost all your money into the pot marked "Litigation" and very little into the pot marked "R&D" you can end up with very few, if any, customers. Pipe fairies, maybe. But not customers for your products. And if you quit selling Linux just as it really starts to take off, well, as my mom used to tell me when I was a kid and made poor decisions, "You made your bed. Now you must lie in it."

Their R&D expenses were actually up a bit, but that was, they say, "primarily attributable to increased travel costs and from stock-based compensation."

Of course that isn't the primary problem. Their primary problem I would think would be persuading their customers that they'll still be around a year from now. SCO first says this:

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.

OK. That's in the Legal section. But a little further down, they repeat that information, and then they add this:

Because these matters are not probable or estimable, we have not recorded any reserves or contingencies related to these legal matters. In the event that our assumptions used to evaluate these matters as neither probable nor estimable changes in future periods, we may be required to record a liability for an adverse outcome, which could have a material adverse effect on our results of operations and financial position.

I'm not an accountant, but that reads to me like they have nothing set aside and don't plan to set anything aside to pay damages with in the "improbable" event that they lose to IBM et al, because who'd a thunk they might lose? What could be more improbable than SCO losing? And even if it were likely, they don't know how much they'd have to pay. So la de da, no need to plan for an improbable and impossible to estimate rainy day. Here's an article [PDF] that explains the financial accounting rules that SCO is referencing:

Apart from those purely legal considerations, you also must help determine whether the company is required to recognize the potential loss contingency in the financial statements and disclose the existence of the potential suit to shareholders. ...If you reach the wrong decision, your company could be required to restate its financial statements, and perhaps face shareholder litigation, SEC enforcement action, or criminal charges....

A loss contingency is a loss (i.e., the impairment of an asset or the incurrence of a liability) arising from a past event, the amount of which, if any, will be confirmed by a future event that is not within the company's control.

Examples of loss contingencies include, but are not limited to, the threat of or pending lawsuits against the corporation, or its officers if they have been indemnified by the company.

Such a contingency can, in certain cases, obligate the corporation to record a reserve in anticipation of a judgment against the corporation or a settlement, or perhaps disclose the existence of the contingency in its financial statements....

In particular, FAS 5, which establishes standards for financial accounting and reporting for loss contingencies, dictates in paragraph eight that a loss contingency must be recognized as a charge to income if both of the following standards are met:

a. Information available prior to issuance of the financial statement indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss; and

b. The amount of loss can be reasonably estimated.

...However, even if in-house counsel and accounting arrive at a consensus that no accrual must be made because the two conditions in paragraph eight have not been satisfied, the corporation may still be required to make a disclosure of the contingency if it is determined to be reasonably possible.

In such a case, a corporation must "indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made."

There are exceptions to this rule, however. A corporation would not always be required to disclose a loss contingency where the claim is unasserted, such as where the potential claimant has not demonstrated an awareness of an entitlement to a claim. If, however, it is probable that a claim will be asserted, and there is a reasonable possibility that the claimant will prevail on such claim, then a disclosure is mandated.

Well. That was interesting. There's a lot more in the article. It's well worth reading, particularly in this context. Is it really so that one cannot even provide a reasonable ball park guesstimate of damages if SCO loses? Um. Now that IBM's experts have provided their expertise? Here's the definitions of gradations of likelihood in the rule:

A future event confirming the amount a loss contingency is reasonably possible, the statement provides, when "the chance of the future event or events occurring is more than remote but less than likely." On the other hand, such a chance is remote when "the chance of the future event or events occurring is slight." If the loss contingency is determined to be probable, the loss should be recognized, provided it can be reasonably estimated.

Losing to IBM is not "more than remote"? And can you imagine what their financials would look like if they actually didn't decide such a contingency was improbable and not estimable? Not just red ink. They'd have to invent a new color. Then in the Risks section, SCO says this:

If we do not prevail in our action against IBM, or if IBM is successful in its counterclaims against us, our business and results of operations would be materially harmed and we may not be able to continue in business.

That's the part that may be scaring off customers. Do they sincerely believe losing the IBM litigation is in the improbable category? Then there are these ominous-sounding words, at least if one is looking for a long-term relationship:

Because of the unique and unpredictable nature of the SCO Litigation, the occurrence and timing of certain expenses is difficult to predict, and will be difficult to predict for the upcoming quarters. We will continue to make payments for technical, damage and industry experts, consultants and for other fees. However, future legal fees may include contingency payments made to the Law Firms as a result of a settlement, judgment, or a sale of our Company, which could cause the cost of SCOsource licensing revenue for the three months ending October 31, 2006 to be higher than the costs incurred for the three months ended July 31, 2006.

The case doesn't go to trial until February of 2007, so a judgment before October is pretty much out. IBM has shown zero interest in settling. So that leaves sale of the company. Things that make you go hmm. If I were an employee, I'd probably notice this section:

General and administrative expenses consist of the salaries and benefits of finance, human resources, and executive management and expenses for professional services and corporate allocations. General and administrative expenses increased by $182,000, or 11%, during the three months ended July 31, 2006 as compared to the three months ended July 31, 2005. The increase in general and administrative expenses was primarily attributable to increased professional services costs and stock-based compensation, offset in part by decreased personnel and related costs. General and administrative expenses decreased by $307,000, or 6%, during the nine months ended July 31, 2006 as compared to the nine months ended July 31, 2005. The decrease in general and administrative expenses was primarily attributable to decreased personnel and related costs as well as decreased accounting and legal fees, offset, in part, by an increase in stock-based compensation. Included in general and administrative expenses for the three months ended July 31, 2006 and 2005 was $264,000 and $0, respectively, of stock-based compensation. Included in general and administrative expenses for the nine months ended July 31, 2006 and 2005 was $736,000 and $0, respectively, of stock-based compensation. For the three months ending October 31, 2006, we anticipate that the dollar amount of general and administrative expenses will be lower than that incurred during the three months ended July 31, 2006.

Time to dust off that resume? They seem to be losing service contracts too:

Services revenue consists primarily of technical support fees, engineering services fees, professional services fees and consulting fees. These fees are typically charged and invoiced separately from UNIX products sales. The decrease in services revenue of $179,000, or 13%, for the three months ended July 31, 2006 as compared to the three months ended July 31, 2005 and the decrease in services revenue of $358,000, or 8%, for the nine months ended July 31, 2006 as compared to the nine months ended July 31, 2005 was primarily attributable to a decrease in professional services revenue as well as from a decrease in support and engineering services contracts.

It's just crazy woe after woe. It probably wasn't received well that they started suing their own customers. Folks started lining up at the Exit signs. I guess SCO must feel they flew past the point of no return, and they are course committed now. But it's suicide by courtroom and it's hard to watch. Just think for a minute if they'd put $34 1/2 million into R&D and marketing instead of this wacko litigation. Or just fed the world's hungry. Even that would have made more sense than this endless gushing of money out of every body cavity SCO has straight into their lawyers' pockets. Well, one of the lawyers is Darl's brother, so at least some of it is staying in the family.


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