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SCO's Quarterly Report -- UNIX Is Mine, All Mine
Monday, June 16 2003 @ 01:27 AM EDT



SCO has filed its quarterly report with the Securities and Exchange Commission, for the quarter ending April 30, 2003, and it's most revealing. The first thing that leaps off the page is the fact that the Microsoft licensing deal does not necessarily extend beyond 2003. They do have an option to extend at their election. And the second licensee, with the mystery unnamed licensee, is a prior licensee, and the license was what the report calls "a clean-up" license. In other words, it appears that MS is the only company to respond favorably to SCOsource so far, although they list the second as a SCOsource win.

In connection with one license agreement SCO says they "granted a warrant to the licensee to purchase up to 210,000 shares of our common stock, for a period of five years, at a price of $1.83 per share. This warrant has been valued, using the Black-Scholes valuation method, at $500,000. Because the warrant was issued for no consideration, $500,000 of the license proceeds have been recorded as warrant outstanding and the license revenue reduced accordingly."

The next thing that leaps off the page, specifically on page 33, is that it is only the license money that made them show a profit this last quarter. Everything else is down:

"Our revenue from the sale of UNIX based products has declined since we acquired these operations from Tarantella. This decrease in revenue has been attributable to the worldwide economic slowdown as well as from competitive pressures from alternative operating systems. If the demand for UNIX based products continues to decline, and we are unable to develop new products and services that successfully address a market demand, our business will be adversely affected."

On page 17, under the heading "Significant Customers", it says:

"During the three and six months ended April 30, 2003, two customers accounted for approximately 39 percent and 24 percent, respectively, of the Company[base ']s total revenue. There were no outstanding receivables from these two customers as of April 30, 2003. During the three and six months ended April 30, 2002, the Company did not have any customers that accounted for more than 10 percent of total revenue. "

As SCO puts it in their list of "Risk Factors", "We do not have a history of profitable operations" and "Our future SCOsource licensing revenue is uncertain. . . . SCOsource licensing revenue is unlikely to produce stable, predictable revenue for the foreseeable future."

The next thing that leaps off the page, on page 30, is what they say about their stock:

"Our stock price is volatile. The trading price for our common stock has been volatile, ranging from a low closing sales price of $1.09 in mid February 2003, to recent highs in excess of $9.00 per share. The share price has changed dramatically over short periods with increases and decreases of over 25 percent in a single day. We believe that the changes in our stock price are affected by changing public perceptions concerning the strength of our intellectual property claims and other factors beyond our control. Public perception can change quickly and without any change or development in the underlying facts. An investment in our stock is subject to such volatility and, consequently, is subject to significant risk. ...Fluctuations in our quarterly operating results or our failure to meet the expectations of analysts or investors, even in the short-term, could cause our stock price to decline. Because of the potential for significant fluctuations in our SCOsource revenue in any particular period, you should not rely on quarter-to-quarter comparisons of our results of operations as an indication of future performance. "

It also appears that SCO has been issuing stock/options instead of money to "key employees", board members, and others: "During the six months ended April 30, 2003, the Company issued 218,000 shares of restricted stock to certain key employees and 150,000 shares of restricted common stock to members of the Company's board of directors. The restricted common stock issued to the board of directors was in lieu of cash compensation for their services to the Company during the 2003 fiscal year and the restrictions lapse at October 31, 2003. The restrictions on the restricted stock awards granted to key employees lapse over a period of 24 months. The fair value of the restricted stock awards granted of $549,000 was recorded as a component of deferred compensation and is amortized to stock-based compensation as the restrictions lapse or as the services are performed.... During the six months ended April 30, 2003, the Company issued a ten-year option to acquire 100,000 shares of the Company's common stock at $1.52 per share to a consultant for services. The option vests as follows, (i) options to purchase 50,000 shares vest on a monthly basis over a 12-month period, and (ii) the remaining options to purchase 50,000 shares vest upon the achievement of certain milestones. The fair value of the options will be determined and recorded as expense in the periods the services are performed and the milestones are achieved. During the quarter ended April 30, 2003, the Company recorded $131,000 of expense related to this option. For the six months ended April 30, 2003, the Company recorded $186,000 of expense related to this option."

That is on page 14. On page 15, it says this:

"Warrant Agreement -- During the quarter ended April 30, 2003, the Company issued a warrant to a SCOsource licensee. The warrant allows the licensee to acquire 210,000 shares of the Company's common stock at an exercise price of $1.83 per share for a term of five years from the date of grant. Because the warrant was issued for no consideration to the SCOsource licensee, the Company has recorded the fair value of the warrant of $500,000, as determined using the Black-Scholes option-pricing model, as a warrant outstanding during the quarter ended April 30, 2003 and reduced license revenue accordingly. "

Is this voting stock? Then on page 34 it says this:

"Future sales of our common stock may negatively affect our stock price. Certain holders of our common stock have demand and piggyback registration rights obligating us to register their shares under the Securities Act for sale. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market, or the perception that such sales could occur. This also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate."

Is that saying what I think it is? On page 12, it explains that some of the information in the report is a bit vague:

"Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America 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[base ']s most recent annual report on Form 10-K, are adequate to make the information presented not misleading."

Also, it seems that SCO is the defendant in at least two other active lawsuits, one of them in connection with allegations of violations of the securities laws:

"Beginning in July 2001, the Company, certain of its officers and directors, and the underwriters of the Company's initial public offering were named as defendants in a series of class action lawsuits filed in the United States District Court for the Southern District of New York (the 'Actions') by parties alleging violations of the securities laws. The complaints were subsequently amended and consolidated into a single complaint. The consolidated complaint alleges certain improprieties regarding the circumstances surrounding 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. The consolidated complaint also alleges that, whether or not the Company's officers or directors were aware of the underwriters' conduct, the Company and those officers and directors have statutory liability under the securities laws for issuing a registration statement in connection with the Company's initial public offering that failed to disclose that conduct....The initial round of motions to dismiss under the securities laws were recently denied on the basis that the Plaintiffs had alleged, but not proven, proper causes of action. The actions are now in the discovery phase of litigation. "

They list risk factors from the litigaton with IBM:

"Pursuit of the litigation against IBM and, potentially, others will be costly, and management expects the costs for legal fees could be substantial. In addition, the Company may experience a decrease in revenue as a result of the loss of sales of Linux products and initiatives previously undertaken jointly with IBM and others affiliated with IBM. The Company anticipates that participants in the Linux industry will seek to influence participants in the markets in which we sell our products to reduce or eliminate the amount of our products and services that they purchase. There is also a risk that the assertion of the Company's intellectual property rights will be negatively viewed by participants in our marketplace and we may lose support from such participants."

Then there is this about their employee stock purchase plan on page 16:

"Employee Stock Purchase Plan -- On November 30, 2002, employees participating in the Company's employee stock purchase plan acquired 87,500 shares of the Company's common stock at a price of $0.66 per share. On May 31, 2003, 258,000 shares of the Company[base ']s common stock were acquired at prices between $0.66 and $1.38 per share.

They valued the stock like this:

"Assumptions used in the Black-Scholes option-pricing model to determine the fair value of the options vested during the quarter ended April 30, 2003 were the following: estimated fair value of common stock of $2.66 per share; risk-free interest rate of three percent; expected dividend yield of 0 percent; volatility of 232 percent; and expected exercise life of ten years. "

But the most striking part of the report to me was this section, on page 20:

"One of the assets we acquired from Tarantella was the intellectual property rights to UNIX. These rights had initially been developed by AT&T Bell Labs and over 30,000 licensing and sublicensing agreements have been entered into with approximately 6,000 entities. These licenses led to the development of several proprietary UNIX-based operating systems, including our own SCO UnixWare and SCO OpenServer, Sun[base ']s Solaris, IBM's AIX, SGI's IRIX, HP's UX, Fujitsu's ICL DRS/NX, Siemens' SINIX, Data General's DG-UX, and Sequent's DYNIX/Ptx. We believe these operating systems are all derivatives of the original UNIX source code owned by us." [Emphasis added]

Are they planning on suing everybody using any kind of UNIX? That would take the old UNIX wars to a new height. The reason I wonder is they say in connection with their claim against Linux that it is based not only on allegedly stolen code but on "unauthorized derivatives of UNIX source code". If they now view all forms of UNIX as derivatives... well, you can imagine the ka-ching going off in their heads. Haven't they learned anything from the result of the UNIX wars, namely that it was precisely all the proprietary efforts, which made UNIX not so interoperable and not so pleasant, that gave Linux its chance to take off and fly? And now they want to do that some more? Is that the only way they know how to do business? They do prudently add this to the report:

"The success of our SCOsource licensing initiative, at least initially, will depend to a great extent on the perceived strength of our intellectual property and contractual claims and our willingness to enforce our rights. Many, particularly those in the open source community, dispute the allegations of infringement that we have made.... While our SCOsource initiative has already resulted in significant revenue during the April 30, 2003 quarter and we continue negotiations with other industry participants that we believe will lead to additional contracts, as a result of the factors outlined above, we are unable to predict the level or timing of future revenue from this source, if any."

It seems that they have bet the farm on SCOsource:

"LIQUIDITY AND CAPITAL RESOURCES -- Since inception, we have funded our operations primarily through loans from our major stockholder and through sales of common and preferred stock. During the first two quarters of 2003, our operations produced positive cash flow for the first time in our history. Although we believe that we will have sufficient financial resources to fund operations for the remainder of fiscal year 2003, however, if we are unable to continue to generate positive cash from operations we will not be able to implement our business plan without additional funding, which may not be available to us." (p. 26)

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