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SCO's 10K: Now What? Caveat Emptor
Wednesday, January 30 2008 @ 03:38 PM EST

SCO has filed its 10K Annual Report for the fiscal year ended October 31, 2007. What a year it has been. They are down to 115 employees as of that date. Probably less now. They "anticipate a reduction in force as a result of Chapter 11 bankruptcy and in order to return to profitability". Uh huh. Product revenue is down 27%. They expect that to continue. They can't guarantee they'll make it out of Chapter 11. Those they owe money to could be left with nothing or almost nothing. Common shareholders are in the same boat, even if they do successfully implement a reorganization:
A plan of reorganization may result in holders of our common stock receiving no distribution on account of their interests and cancellation of their common stock....Therefore, an investment in our common stock is highly speculative.

You probably don't need a warning from SCO about the stock at this point.

Given their legal costs, a return to profitability might never come:

"As of October 31, 2007, we had a total of $5,554,000 in cash and cash equivalents and an additional $3,099,000 of restricted cash of which $1,833,000 to be used to pursue the SCO Litigation. Since October 31, 2004, we have spent a total of $13,167,000 for expert, consulting and other costs and fees as agreed to in the Engagement Agreement with our legal counsel in the SCO Litigation. Our limited cash resources may not be sufficient to fund continuing losses from operations and the expenses of the SCO Litigation."

They made some money from investments:

Our investing activities have historically consisted of equipment purchases and the purchase and sale of available-for-sale marketable securities. During the year ended October 31, 2007, cash provided by investing activities was $2,159,000, which was primarily a result of proceeds from the sale of available-for-sale marketable securities of $2,249,000, offset, inpart, by purchases of equipment of $90,000.

They can't guarantee being able to make it out of Chapter 11:

A prolonged continuation of the Chapter 11 cases may also require us to seek financing. If we require financing during the Chapter 11 cases and we are unable to obtain the financing on favorable terms or at all, our chances of successfully reorganizing our businesses may be seriously jeopardized.

What about appealing the adverse judgment in Utah? SCO can't even guarantee it will be able to do that:

We cannot guarantee the success of our SCO Litigation including, the appeal of the adverse August 10, 2007 summary judgement ruling or even our ability to take such an appeal and other efforts to protect and enforce our intellectual property rights, but we will continue to seek to enforce and pursue these rights through the judicial system.

Except it lacks the funds to do so, unless it can get financing, which it can't be sure it can get. What does that mean for those with claims against SCO?:

If our Plan is not confirmed by the Bankruptcy Court, it is unclear whether we would be able to reorganize our businesses and what, if anything, holders of claims against us would ultimately receive with respect to their claims. If an alternative reorganization could not be agreed upon, it is possible that we would have to liquidate our assets, in which case it is likely that holders of claims would receive substantially less favorable treatment than they would receive if we were to emerge as a viable, reorganized entity.

Here's the Overview section:

We have ownership rights in the base UNIX operating system technology and are a provider of UNIX-based products and services. We own the business related to this technology as well as innovative mobile software technology. Our core business is to sell and service our UNIX software products to small-to-medium sized businesses and franchisees or branch offices of Fortune 1000 businesses. The products that drive the majority of our UNIX revenue are OpenServer and UnixWare. We intend to continue to develop, market and service our UNIX products and services during the year ending October 31, 2008, while at the same time further developing and marketing our mobility products and services for personal and professional productivity.

We developed our SCOsource business as part of our ongoing efforts to establish and protect our intellectual property rights, particularly relating to our ownership interest in the original UNIX source code. Our primary objective with this business is to protect and defend our UNIX rights.

Whatever they turn out to be. Of course, it had to address the issue of the August 10th ruling in SCO v. Novell. Here's the section about that:

On August 10, 2007, the federal judge overseeing our lawsuit with Novell, Inc. (“Novell”) ruled in favor of Novell on several of the summary judgment motions that were before the United States District Court in Utah (the “Court”). The effect of these rulings was to significantly reduce or eliminate certain of our claims in both the Novell and IBM cases, and possibly others. The Court ruled that Novell was the owner of the UNIX and UnixWare copyrights that existed at the time of the 1995 Asset Purchase Agreement and that Novell retained broad rights to waive our contract claims against IBM. The Court ruled that we own the copyrights to post 1995 derivatives and that we have certain other ownership rights and licenses in the UNIX technology. We were directed to accept Novell’s waiver of our UNIX contract claims against IBM. In addition, the Court determined that certain SCOsource licensing agreements included older SVRx licenses and that we were possibly required to remit some portion of the proceeds to Novell. Over our objection, a bench trial was set to begin on September 17, 2007 and the federal judge was to determine what portion, if any, of the proceeds of the SCOsource agreements is attributable to such SVRx licenses and should be remitted to Novell. The range of the payment to Novell is from a de minimis amount to in excess of $30,000,000, the latter amount being the amount claimed by Novell, plus interest. Novell has sought to impose a constructive trust on our current funds traceable to those sources, which could result in a freeze of our assets, and the Court indicated that it would address that issue as well.

The trial of these issues, however, was stayed as a result of our filing a voluntary petition for relief under Chapter 11 of the Bankruptcy Code on September 14, 2007. Our management and Board of Directors determined that filing for relief under Chapter 11 of the United States Bankruptcy Code was appropriate and necessary. As a result of both the Court’s August 10, 2007 ruling and our entry into Chapter 11, among other matters, there is substantial doubt about our ability to continue as a going concern. Absent a significant cash payment to Novell for this matter, management believes that the undiscounted future cash flows generated by us will be sufficient to recover the carrying amounts of our long-lived assets over their expected remaining useful lives. However, if a significant cash payment is required, or significant assets are put under a constructive trust, the carrying amounts of our long-lived assets may not be recovered (which totaled $359,000 as of October 31, 2007). Our financial statements do not include any adjustments that might result from the outcome of these uncertainties. The bankruptcy court in Delaware has ruled that it will retain jurisdiction over the constructive trust issue but lifted the stay to allow Novell’s claims for amounts due under the SCOsource agreements and our authority to enter into those licenses to go to trial in federal court in Utah. A four-day bench trial has been scheduled for April 29, 2008, in the U.S. District Court in Utah. Novell has determined to file a motion for summary judgment on the issue of whether we had the authority to enter into the SCOsource licenses and we are currently briefing that motion. The bankruptcy court in Delaware also ruled that the bankruptcy stay applies to the SuSE arbitration proceeding pending in Europe.

We intend to maintain business operations throughout the reorganization process. Subject to bankruptcy court’s approval, we will use our cash, cash equivalents, restricted cash and subsequent cash inflows to meet our working capital needs throughout the reorganization process.

As for the bankruptcy itself, SCO says this:

As a result of the Chapter 11 filings, realization of assets and liquidation of liabilities are subject to uncertainty. While operating as debtors-in-possession under the protection of Chapter 11 of the Bankruptcy Code, the Debtors may sell or otherwise dispose of assets and liquidate or settle liabilities for amounts other than those reflected in the consolidated financial statements, in the ordinary course of business, or, if outside the ordinary course of business, subject to Bankruptcy Court approval.

In addition, under the priority scheme established by the Bankruptcy Code, unless creditors agree otherwise, post-petition liabilities and prepetition liabilities must be satisfied in full before stockholders are entitled to receive any distribution or retain any property under a plan of reorganization. The ultimate recovery by creditors and/or stockholders, if any, will not be determined until confirmation of a plan or plans of reorganization. No assurance can be given as to what values, if any, will be ascribed in the Chapter 11 cases to each of these constituencies or what types or amounts of distributions, if any, they would receive. A plan of reorganization could result in holders of our stock receiving no distribution on account of their interests and cancellation of their existing stock. If certain requirements of the Bankruptcy Code are met, a plan of reorganization can be confirmed notwithstanding its rejection by our equity security holders and notwithstanding the fact that such equity security holders do not receive or retain any property on account of their equity interests under the plan. Accordingly, we urge that the appropriate caution be exercised with respect to existing and future investments in any of these securities as the value and prospects are highly speculative.

Under the supervision of the Bankruptcy Court, we may decide to pursue various strategic alternatives as deemed appropriate by our Board of Directors to serve the best interests of the Company and our stockholders, including asset sales or strategic partnerships.

Buyer beware, in other words, as I read it. Here's their plan for the immediate future, subject to the clue about asset sales and/or strategic partnerships:

Sales of our UNIX-based products and services have been declining over the last several years. This decline in revenue has been primarily attributable to significant competition from alternative operating systems, particularly Linux. Our expectation is that this trend will continue as a result of continued competition, the negative ruling received from our litigation with Novell, and our Chapter 11 filing.

We anticipate that our OpenServer and UnixWare products will continue to provide a future revenue stream for our UNIX business. However, unless there is a change in the current operating system environment, we expect revenue from these products will continue to decline. Both of these UNIX products have a strong and loyal existing customer base of small-to-medium businesses and enterprise customers and constitute a well-known brand with a reputation for quality and reliability.

We also have a seasoned, mature sales channel of resellers focused on the small-to-medium size business market. This channel is a unique asset that should allow us to continue to provide reliable UNIX operating systems for small-to-medium sized business customers.

For the fiscal year ending October 31, 2008, we plan to continue to focus our UNIX development resources on our current UNIX products. In addition, we will focus other engineering resources on our mobility products and services for personal and professional productivity. We expect that these mobility products and services will enable easy, secure, real-time mobile access to all kinds of information stored in enterprise and web-based systems without the need for direct connection between end-point devices and those systems.

They've spent "$6,077,000, $8,045,000 and $8,337,000 in research and development expense during the years ended October 31, 2007, 2006 and 2005, respectively".

What about if there is a constructive trust?

If the Court imposes a constructive trust on proceeds of the fiscal year 2003 SCOsource agreements, we may not be able to continue in business. The federal district judge overseeing our lawsuit with Novell had scheduled a bench trial that was set to begin on September 17, 2007. At that time the federal judge was to determine what portion, if any, of the proceeds of the SCOsource agreements are attributable to older SVRx licenses and should be remitted to Novell, and whether SCO has the authority to enter into certain SCOsource agreements beginning in 2003, including large transactions with Sun and Microsoft. The determination of the amount of proceeds payable to Novell is from a de minimis amount to in excess $30,000,000, the latter amount being the amount claimed by Novell, plus interest. Novell has sought to impose a constructive trust on our current funds traceable to these sources. The trial of these issues, however, was stayed as a result of our filing a voluntary petition for relief under Chapter 11 of the Bankruptcy Code on September 14, 2007. Novell filed a motion seeking relief from the automatic stay to continue the trial. If the Bankruptcy Court imposes a constructive trust in an amount that exceeds our cash and cash equivalents and restricted cash, or if the amounts subject of the constructive trust are otherwise significant, we may not be able to continue to operate our business. The bankruptcy judge in Delaware has ruled that the Bankruptcy Court will retain jurisdiction over the constructive trust issue but lifted the stay to allow Novell’s claims for amounts due under the SCOsource agreements and our authority to enter into those licenses to go to trial in federal court in Utah. A four-day bench trial has been scheduled for April 29, 2008 in the U.S. District Court in Utah. It is not known when the constructive trust issue will be addressed. Our claims relating to our UNIX intellectual property may subject us to additional legal proceedings.

In August 2003, Red Hat brought a lawsuit against us asserting that the Linux operating system does not infringe our UNIX intellectual property rights and seeking a declaratory judgment for non-infringement of copyrights and non-misappropriation of trade secrets. In addition, Red Hat claims we have engaged in false advertising in violation of the Lanham Act, deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, and trade libel and disparagement. This case is currently stayed pending the resolution of our suit against IBM and because of the bankruptcy proceedings. If Red Hat is successful in its claim against us, our business and results of operations could be materially harmed.

So, what about the stock folks already hold?

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

As of December 31, 2007, we have issued outstanding options to purchase up to approximately 5,016,000 shares of common stock with an average exercise price of $3.53 per share. The existence of such rights to acquire common stock at fixed prices may prove a hindrance to our efforts to raise future equity and debt funding, and the exercise of such rights will dilute the percentage ownership interest of our stockholders and may dilute the value of their ownership. The possible future sale of shares issuable on the exercise of outstanding options could adversely affect the prevailing market price for our common stock. Further, the holders of the outstanding stock options may exercise them at a time when we would otherwise be able to obtain additional equity capital on terms more favorable to us. Common stock available for resale may depress the market price of our common stock.

We have filed a post-effective amendment to a registration statement with the Securities and Exchange Commission (“SEC”), which has been declared effective, covering the potential resale by two of our stockholders of up to 923,019 shares of common stock, or 4.3% of our outstanding common stock. The selling stockholders are bound by certain selling limitations, which limit the number of shares of our common stock that may be sold at one time. In addition, we have filed a registration statement with the SEC, which has been declared effective, covering the potential resale by some of our stockholders of up to 2,852,449 shares of our common stock, or 13.3% of our outstanding common stock. The existence of a substantial number of shares of common stock subject to immediate resale could depress the market price for our common stock and impair our ability to raise needed capital.

In short, they learned nothing. They are sorry for nothing. They're still looking to make some money somehow, but not for common shareholders or those they owe money to. They'd like not to be held responsible for any of the damage they've caused. Well, that's my reading of this 10K. So long, suckers. Thanks for all the fish.


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