e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark one)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended January 31, 2007


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number 0-29911

THE SCO GROUP, INC.

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		87-0662823 (I.R.S. Employer Identification Number)

355 South 520 West
Suite 100
Lindon, Utah 84042
(Address of principal executive offices and zip code)

(801) 765-4999
(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

Large Accelerated Filer o Accelerated Filer o Non-accelerated Filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). (Check one): YES o NO þ

As of March 14, 2007, there were 21,233,105 shares of the Registrant’s common stock, $0.001 par value per share, outstanding.

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 in connection with its efforts to promote the Linux operating system. The Company’s complaint includes, among other things, claims for breach of contract, unfair competition, tortious interference and copyright infringement. The Company is seeking damages in an amount to be proven at trial and seeking injunctive relief.

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 $0.87per 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

Our critical accounting policies and estimates include the following:

	•		Revenue recognition;

	•		Deferred income taxes and related valuation allowances;

	•		Litigation reserves;

	•		Impairment of property and equipment; and

	•		Allowances for doubtful accounts.

Revenue Recognition. We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, as modified by SOP 98-9. Our revenue has historically been from three sources: (i) product license revenue, primarily from product sales to resellers, end users and OEMs; (ii) technical support service revenue, primarily from providing technical support and consulting services to end users; and (iii) revenue from SCOsource licensing.

We recognize 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 our revenue transactions relate to product-only sales. On occasion, we have revenue transactions that have multiple elements (such as software products, maintenance, technical support services, and other services). For software agreements that have multiple elements, we allocate 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. We recognize 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

- 17 -

revenue in the period when persuasive evidence of an arrangement is obtained assuming all other revenue recognition criteria are met.

We recognize 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.

We consider an arrangement with payment terms longer than our normal business practice not to be fixed or determinable and revenue is recognized when the fee becomes due. We typically provide stock rotation rights for sales made through our distribution channel and sales to distributors are recognized upon shipment by the distributor to end users. For direct sales not through our distribution channel, sales are typically non-refundable and non-cancelable. We estimate our product returns based on historical experience and maintain an allowance for estimated returns, which is recorded as a reduction to accounts receivable and revenue.

Our SCOsource revenue to date has been primarily generated from agreements to utilize our UNIX source code as well as from intellectual property compliance agreements. We recognize 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 our normal payment terms, revenue is recognized as the payments become due.

Deferred Income Tax Assets and Related Valuation Allowance. The amount, and ultimate realization, of our deferred income tax assets depends, in part, upon the tax laws in effect, our future earnings, if any, and other future events, the effects of which cannot be determined. We have provided a valuation allowance of $76,385,000 against our entire net deferred income tax assets as of October 31, 2006. The valuation allowance was recorded because of our history of net operating losses and the uncertainties regarding our future operating profitability and taxable income.

Litigation Reserves. We are party to a number of legal matters described in more detail elsewhere in this Form 10-Q, including under Part II, Item I – Legal Proceedings. Pursuit and defense of these matters will be costly, and management expects the costs for legal fees and related expenses will be substantial. A material, negative impact on our results of operations or financial position from the Red Hat, Inc., IPO Class Action, or Indian Distributor matters, or the IBM and Novell counterclaims is neither probable nor estimable. 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 change 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, financial position and liquidity.

Impairment of Property and Equipment. We review our long-lived assets for impairment at each balance sheet date and when events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. The carrying value of a long-lived asset is considered impaired when the anticipated cumulative undiscounted cash flows of the related asset or group of assets is less than the carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the estimated fair market value of the long-lived asset. Economic useful lives of long-lived assets are assessed and adjusted as circumstances dictate.

- 18 -

Write-downs of long-lived assets may be necessary if the future fair value of these assets is less than the carrying value. If the operating trends for our UNIX or SCOsource businesses continue to decline, we may be required to record an impairment charge in a future period related to the carrying value of our long-lived assets.

Allowance for Doubtful Accounts Receivable. We offer credit terms on the sale of our products to a majority of our customers and require no collateral from these customers. We perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts based upon our historical collection experience and a specific review of customer balances to determine expected collectibility. Our policies for determining allowances for doubtful accounts have been applied consistently. Our allowance for doubtful accounts receivable was $79,000 as of January 31, 2007. We have not experienced material differences from the actual amounts provided for bad debts and our recorded estimates. However, our actual bad debts in future periods may differ from our current estimates and the differences may be material, which may have an adverse impact on our future accounts receivable and cash position.

Results of Operations

The following table presents our results of operations for the three months ended January 31, 2007 and 2006:


	Three Months Ended January 31,
Statement of Operations Data:	2007			2006
Revenue:
Products	$	4,866,000		$	6,000,000
SCOsource licensing		23,000			30,000
Services		1,126,000			1,313,000

Total revenue		6,015,000			7,343,000

Cost of revenue:
Products		377,000			584,000
SCOsource licensing		654,000			4,010,000
Services		559,000			637,000

Total cost of revenue		1,590,000			5,231,000

Gross margin		4,425,000			2,112,000

Operating expenses:
Sales and marketing		2,440,000			2,688,000
Research and development		1,759,000			1,871,000
General and administrative		1,323,000			1,592,000
Amortization of intangibles		—			592,000

Total operating expenses		5,522,000			6,743,000

Loss from operations		(1,097,000	)		(4,631,000	)

Equity in income (loss) of affiliate		42,000			(8,000	)
Other income, net		143,000			145,000
Provision for income taxes		(112,000	)		(87,000	)

Net loss	$	(1,024,000	)	$	(4,581,000	)

THREE MONTHS ENDED JANUARY 31, 2007 AND 2006

Revenue


	Three Months Ended January 31,
	2007		Change			2006
Revenue	$	6,015,000		(18	)%	$	7,343,000

- 19 -

Revenue for the three months ended January 31, 2007 decreased by $1,328,000, or 18%, from the three months ended January 31, 2006. This decrease was primarily attributable to a continued decline in our UNIX business as a result of continued competitive pressure from competing operating systems, particularly Linux.

Revenue generated from our UNIX business and SCOsource business is as follows:


	Three Months Ended January 31,
	2007			Change			2006
UNIX revenue	$	5,992,000			(18	)%	$	7,313,000
Percent of total revenue		100	%					100	%
SCOsource revenue		23,000			(23	)%		30,000
Percent of total revenue		0	%					0	%

The decrease in revenue in the UNIX business of $1,321,000, or 18%, for the three months ended January 31, 2007 compared to the three months ended January 31, 2006 was primarily attributable to continued competition from other operating systems, particularly Linux. We anticipate that for the remainder of the year ending October 31, 2007 our UNIX business and the related revenue from the UNIX business will continue to face significant competition from Linux and other operating systems.

Sales of our UNIX products and services during the three months ended January 31, 2007 and 2006 were primarily to existing customers. Our UNIX business revenue depends significantly on our ability to market our products to existing customers and to generate upgrades from existing customers. Our UNIX revenue may be lower than currently anticipated if (1) we are not successful with our existing customers, (2) we lose the support of any of our existing hardware and software vendors, or (3) our key industry partners withdraw their marketing and certification support or direct their support to our competitors.

Products Revenue


	Three Months Ended January 31,
	2007			Change			2006
Products revenue	$	4,866,000			(19	)%	$	6,000,000
Percent of total revenue		81	%					82	%

Our products revenue consists of software licenses for UNIX products such as OpenServer and UnixWare, as well as sales of UNIX-related products. Products revenue also includes revenue derived from OEMs, distribution partners and large accounts. We rely heavily on our two-tier distribution channel and any disruption in our distribution channel could have an adverse impact on future revenue.

The decrease in products revenue of $1,134,000, or 19%, for the three months ended January 31, 2007 compared to the three months ended January 31, 2006 was primarily attributable to decreased sales of OpenServer and other products revenue primarily resulting from increased competition in the operating system market, particularly from Linux.

Our products revenue was derived primarily from sales of our OpenServer and UnixWare products. Other products revenue consists mainly of product maintenance and other UNIX-related products. Revenue for these products was as follows:

- 20 -


	Three Months Ended January 31,
	2007			Change			2006
OpenServer revenue	$	2,978,000			(18	)%	$	3,622,000
Percent of products revenue		61	%					60	%
UnixWare revenue		1,471,000			(15	)%		1,725,000
Percent of products revenue		30	%					29	%
Other products revenue		417,000			(36	)%		653,000
Percent of products revenue		9	%					11	%

The decrease in revenue for OpenServer and UnixWare for the three months ended January 31, 2007 compared to the three months ended January 31, 2006 is primarily the result of continued competition from other operating systems, particularly Linux. The decrease in other products revenue is primarily attributable to decreased sales of UNIX-related products and decreased sales of product maintenance.

SCOsource Licensing Revenue


	Three Months Ended January 31,
	2007		Change			2006
SCOsource licensing revenue	$	23,000		(23	)%	$	30,000

We initiated our SCOsource business for the purpose of protecting and defending our intellectual property rights in our UNIX source code and derivative works. SCOsource licensing revenue was $30,000 for the three months ended January 31, 2006 compared 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.

We are unable to predict the amount and timing of future SCOsource licensing revenue, and if generated, the revenue will be sporadic.

Services Revenue


	Three Months Ended January 31,
	2007			Change			2006
Services revenue	$	1,126,000			(14	)%	$	1,313,000
Percent of total revenue		19	%					18	%

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 $187,000, or 14%, for the three months ended January 31, 2007 as compared to the three months ended January 31, 2006 was primarily attributable to the renewal of fewer support and engineering services contracts.

The majority of our support and professional services revenue continues to be derived from services for UNIX-based operating system products. Our future level of services revenue depends in part on our ability to generate UNIX products revenue from new customers as well as to renew annual support and services agreements with existing UNIX customers.

- 21 -

Cost of Products Revenue


	Three Months Ended January 31,
	2007			Change			2006
Cost of products revenue	$	377,000			(35	)%	$	584,000
Percent of products revenue		8	%					10	%

Cost of products revenue consists of manufacturing costs, royalties to third-party vendors, technology costs and overhead costs. Cost of products revenue decreased by $207,000, or 35%, for the three months ended January 31, 2007 as compared to the three months ended January 31, 2006. The decrease in the dollar amount of cost of products revenue was primarily attributable to lower products revenue as margins did not vary considerably.

For the three months ending April 30, 2007, we expect the dollar amount of our cost of products revenue to be generally consistent with the cost of products revenue incurred during the three months ended January 31, 2007 and that cost of products revenue as a percent of products revenue for the three months ending April 30, 2007 will be generally consistent with that incurred during the three months ended January 31, 2007.

Cost of SCOsource Licensing Revenue


	Three Months Ended January 31,
	2007		Change			2006
Cost of SCOsource licensing revenue	$	654,000		(84	)%	$	4,010,000

Cost of SCOsource licensing revenue includes legal and professional fees incurred in connection with our SCO Litigation, the salaries and related personnel costs of SCOsource employees, and an allocation of corporate costs.

Cost of SCOsource licensing revenue decreased by $3,356,000, or 84%, during the three months ended January 31, 2007 as compared to the three months ended January 31, 2006. The decrease in cost of SCOsource licensing revenue was primarily attributable to the absence of the $2,000,000 quarterly payment and related expense for the Law Firms (which quarterly payments ended during the three months ended January 31, 2006), and significant decreases in legal services provided by technical, industry, damage and other experts in connection with the SCO Litigation.

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 April 30, 2007 or for future periods to be higher than the costs incurred for the three months ended January 31, 2007.

Cost of Services Revenue


	Three Months Ended January 31,
	2007			Change			2006
Cost of services revenue	$	559,000			(12	)%	$	637,000
Percent of services revenue		50	%					49	%

- 22 -

Cost of services revenue includes the salaries and related personnel costs of employees delivering services revenue as well as third-party service agreements. Cost of services revenue decreased by $78,000, or 12%, for the three months ended January 31, 2007 compared to the three months ended January 31, 2006. This decrease was primarily attributable to reduced employee and employee-related costs.

For the three months ending April 30, 2007, we expect the dollar amount of our cost of services revenue to be generally consistent with the cost of services revenue incurred during the three months ended January 31, 2007 and that cost of services revenue as a percent of services revenue for the three months ending April 30, 2007 will be generally consistent with that incurred during the three months ended January 31, 2007.

Sales and Marketing


	Three Months Ended January 31,
	2007			Change			2006
Sales and marketing expenses	$	2,440,000			(9	)%	$	2,688,000
Percent of total revenue		41	%					37	%

Sales and marketing expenses consist of the salaries, commissions and other personnel costs of employees involved in the revenue generation process, as well as advertising and corporate allocations. The decrease in sales and marketing expenses of $248,000, or 9%, for the three months ended January 31, 2007 compared with the three months ended January 31, 2006 was primarily attributable to lower travel expenses and reduced discretionary marketing spending as a result of lower revenue. Included in sales and marketing expenses for the three months ended January 31, 2007 and 2006 was $111,000 and $102,000, respectively, for stock-based compensation.

For the three months ending April 30, 2007, we anticipate that the dollar amount of sales and marketing expenses will be generally consistent with that incurred during the three months ended January 31, 2007.

Research and Development


	Three Months Ended January 31,
	2007			Change			2006
Research and development expenses	$	1,759,000			(6	)%	$	1,871,000
Percent of total revenue		29	%					25	%

Research and development expenses consist of the salaries and benefits of software engineers, consulting expenses and corporate allocations. Research and development expenses decreased by $112,000, or 6%, for the three months ended January 31, 2007 compared with the three months ended January 31, 2006. The decrease in research and development expenses was primarily attributable to reduced employee and employee-related costs. Included in research and development expenses for the three months ended January 31, 2007 and 2006 was $43,000 and $41,000, respectively, of stock-based compensation.

For the three months ending April 30, 2007, we anticipate that the dollar amount of research and development expenses will be generally consistent with that incurred during the three months ended January 31, 2007.

- 23 -

General and Administrative


	Three Months Ended January 31,
	2007			Change			2006
General and administrative expenses	$	1,323,000			(17	)%	$	1,592,000
Percent of total revenue		22	%					22	%

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 decreased by $269,000, or 17%, during the three months ended January 31, 2007 as compared to the three months ended January 31, 2006. The decrease in general and administrative expenses was primarily attributable to decreased professional services costs. Included in general and administrative expenses for the three months ended January 31, 2007 and 2006 was $249,000 and $264,000, respectively, of stock-based compensation.

For the three months ending April 30, 2007, we anticipate that the dollar amount of general and administrative expenses will be generally consistent with that incurred during the three months ended January 31, 2007.

Amortization of Intangibles


	Three Months Ended January 31,
	2007			Change			2006
Amortization of intangibles	$	—			(100	)%	$	592,000
Percent of total revenue		0	%					8	%

As of October 31, 2006, all intangible assets had been fully amortized and therefore no amortization expense was recorded during the three months ended January 31, 2007.

Equity in Income (Loss) of Affiliate

We account for our ownership interests in companies in which we own at least 20% and less than 50% using the equity method of accounting. Under the equity method, we record our portion of the entities’ net income or net loss in our consolidated statements of operations. As of January 31, 2007, the carrying value of our investment of $431,000 was for our 30% ownership in a Chinese company.

During the three months ended January 31, 2007 and 2006, we recorded $42,000 and $(8,000), respectively, representing our portion of the net income (loss) in this entity.

Other Income (Expense), net

Other income (expense) consisted of the following components for the three months ended January 31, 2007 and 2006:


	Three Months Ended January 31,
	2007		2006

Interest income	$	114,000	$	152,000
Other income (expense), net		29,000		(7,000	)

Total	$	143,000	$	145,000

- 24 -

Interest income decreased by $38,000 for the three months ended January 31, 2007 as compared to the three months ended January 31, 2006 and was primarily attributable to lower cash and available-for-sale marketable securities balances.

The increase in other income (expense), net, of $36,000 for the three months ended January 31, 2007 as compared to the three months ended January 31, 2006 was primarily attributable to an increase in realized gains as a result of changes in foreign currency rates and balances.

Provision for Income Taxes

The provision for income taxes was $112,000 for the three months ended January 31, 2007 and $87,000 for the three months ended January 31, 2006. Our provision for income taxes is primarily related to earnings in foreign subsidiaries as well as from withholding taxes on revenue generated in certain foreign locations.

Liquidity and Capital Resources

Our cash and cash equivalents balance increased from $5,369,000 as of October 31, 2006 to $7,137,000 as of January 31, 2007. During this same time period, our investment in available-for-sale marketable securities decreased from $2,249,000 as of October 31, 2006 to $500,000 as of January 31, 2007. Total cash and cash equivalents and available-for-sale marketable securities was $7,637,000 as of January 31, 2007. As of January 31, 2007, we also had $4,498,000 of restricted cash, of which $3,979,000 is set aside to cover expert and other costs related to our SCO Litigation and $519,000 is set aside for royalties payable to Novell.

We intend to use the cash and cash equivalents and available-for-sale marketable securities as of January 31, 2007 to run our UNIX business and pursue the SCO Litigation and believe that we have sufficient liquidity resources to fund our operations through October 31, 2007.

Our net cash used in operating activities during the three months ended January 31, 2007 was $220,000 and was attributable to a net loss of $1,024,000, non-cash items of $542,000 and changes in operating assets and liabilities of $262,000.

Our net cash used in operating activities during the three months ended January 31, 2006 was $1,379,000 and was attributable to a net loss of $4,581,000, non-cash items of $1,170,000 and changes in operating assets and liabilities of $2,032,000.

Our investing activities have historically consisted of equipment purchases and the purchase and sale of available-for-sale marketable securities. During the three months ended January 31, 2007, cash provided by investing activities was $1,727,000, which was primarily a result of proceeds from the sale of available-for-sale marketable securities of $1,749,000 offset by purchases of equipment of $22,000.

During the three months ended January 31, 2006, cash used in investing activities was $1,100,000, which was primarily a result of purchases of available-for-sale marketable securities of $1,031,000, and purchases of equipment of $69,000.

Our financing activities provided $234,000 of cash during the three months ended January 31, 2007. The primary sources of cash were from the exercise of options to acquire common stock of $4,000 and proceeds of $230,000 received from the sale of common stock through our employee stock purchase plan.

- 25 -

Our financing activities provided $10,197,000 of cash during the three months ended January 31, 2006. The primary sources of cash were the net proceeds from the issuance of approximately 2,852,000 shares of our common stock for $9,905,000, the exercise of options to acquire common stock of $23,000 and proceeds of $301,000 received from the sale of common stock through our employee stock purchase plan, offset, in part, by the repurchase of shares of our common stock made in connection with the completion of our rescission offer of $32,000.

Our net accounts receivable balance decreased from $5,123,000 as of October 31, 2006 to $4,010,000 as of January 31, 2007, primarily as a result of lower sales (and related invoicing) generated during the three months ended January 31, 2007 as compared to the three months ended October 31, 2006. The majority of our accounts receivable are current and our allowance for doubtful accounts was $79,000 as of January 31, 2007, which represented approximately 2 percent of our gross accounts receivable balance. This percentage of gross accounts receivable is consistent with our experience in prior periods, and we expect this trend to continue. Our write-offs of uncollectible accounts during the three months ended January 31, 2007 and 2006 were not significant.

As described elsewhere in this Form 10-Q, we are continuing to pay for expert, consulting and other expenses relating to our litigation with IBM. These expenses have been material in the past and even though we expect these expenses to be lower for the year ending October 31, 2007 as compared to the year ended October 31, 2006, we expect them to continue to be material to our financial statements.

In addition to the cash expenditures mentioned 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. The contingency fee amounts payable to the Law Firms will be, subject to certain credits and adjustments, as follows:

	•		33 percent of any aggregate recovery amounts received up to $350,000,000;

	•		plus 25 percent of any aggregate recovery amounts above $350,000,000 but less than or equal to $700,000,000;

	•		plus 20 percent of any aggregate recovery amounts in excess of $700,000,000.

The Engagement Agreement provides that, except for the compensation obligations specifically described above, we will not be obligated to pay any legal fees, whether hourly, contingent or otherwise, to the Law Firms, or any other law firms that may be engaged by the Law Firms, in connection with the SCO Litigation through the end of the current litigation between us and IBM, including any appeals.

We have entered into operating leases for our corporate offices located in the United States and our international sales offices. We have commitments under these leases that extend through the year ending October 31, 2008.

The following table summarizes our contractual operating lease obligations as of January 31, 2007:


			Less than						More than
	Total		1 year		1 – 3 years		3 -5 years		5 years
Operating lease obligations	$	1,738,000	$	1,305,000	$	433,000	$	—	$	—

As of January 31, 2007, we did not have any long-term debt obligations, purchase obligations or material capital lease obligations.

- 26 -

Our ability to reduce costs to offset revenue declines in our UNIX business is limited because of contractual commitments to maintain and support our existing UNIX customers. The decline in our UNIX business may be accelerated if industry partners withdraw their support as a result of the SCO Litigation. In addition, the SCO Litigation 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 our UNIX products and services revenue. If our UNIX products and services revenue is less than expected, our liquidity will be adversely impacted.

In the event that cash required to fund operations and strategic initiatives exceeds our current cash resources, we will be required to reduce costs and perhaps raise additional capital. We may not be able to reduce costs in a manner that does not impair our ability to maintain our UNIX business and pursue the SCO Litigation. We may not be able to raise capital for any number of reasons including those listed under the section “Risk Factors” under Part II, Item 1A of this Form 10-Q. If additional equity financing is available, it may not be available to us on attractive terms and may be dilutive to our existing stockholders. In addition, if our stock price declines, we may not be able to access the public equity markets on acceptable terms, if at all. Our ability to effect acquisitions for our common stock would also be impaired.

Forward-Looking Statements and Factors That May Affect Future Results and Financial Condition

With the exception of historical facts, the statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which reflect our current expectations and beliefs regarding our future results of operations, performance and achievements. These statements are subject to risks and uncertainties and are based upon assumptions and beliefs that may or may not materialize. These forward-looking statements include, but are not limited to, statements concerning:

	•		Our intention to vigorously defend legal claims and counterclaims brought against us by others;

	•		Our intention to continue to pursue the SCO Litigation;

	•		Our belief that our allowance for doubtful accounts receivable will remain consistent with our prior experience and that write-offs of uncollectible accounts will not materially exceed that allowance;

	•		The strength of our intellectual property rights and contractual claims regarding UNIX generally and specifically the strength of our claim that unauthorized UNIX source code and derivatives of UNIX source code are prevalent in Linux;

	•		Our belief that competition from Linux will continue during the year ending October 31, 2007 and future periods;

	•		Our expectation that we will continue to be unable to predict the amount and timing of SCOsource licensing revenue, and when generated, the revenue will be sporadic;

	•		Our expectation that future services revenue will depend in part on our ability to generate UNIX products revenue from new customers as well as the renewal of annual support and services agreements from existing UNIX customers;

	•		Our expectation for the three months ending April 30, 2007 that the dollar amount of our cost of products revenue and that cost of products revenue as a percent of products revenue will be generally consistent to that incurred during the three months ended January 31, 2007;

	•		Our expectation for the three months ending April 30, 2007 that the dollar amount of our cost of services revenue and that cost of services revenue as a percent of

- 27 -

			services revenue will be generally consistent to that incurred during the three months ended January 31, 2007;

	•		Our expectation for the three months ending April 30, 2007 that the dollar amount of our sales and marketing expenses will be generally consistent to that incurred during the three months ended January 31, 2007;

	•		Our expectation for the three months ending April 30, 2007 that the dollar amount of our research and development expenses will be generally consistent to that incurred during the three months ended January 31, 2007;

	•		Our expectation for the three months ending April 30, 2007 that the dollar amount of our general and administrative expenses will be generally consistent to that incurred during the three months ended January 31, 2007;

	•		Our intention to use cash and cash equivalents and available-for-sale marketable securities to run our UNIX business and pursue the SCO Litigation;

	•		Our intention to continue to pay for expert, consulting and other expenses through the conclusion of our litigation with IBM, and our expectation that although these expenses are expected to decrease for the year ending October 31, 2007 as compared to the year ended October 31, 2006, that they will continue to be material to our financial statements;

	•		Our expectation for the three months ending April 30, 2007 that 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; and

	•		Our belief that certain legal actions to which we are a party will not have a material adverse effect on us.

We wish to caution readers that our operating results are subject to various risks and uncertainties that could cause our actual results and outcomes to differ materially from those discussed or anticipated, including the resolution of the SCO Litigation, competition from other operating systems, particularly Linux, the amount and timing of SCOsource licensing revenue, our ability to enhance our UNIX operating systems and maintain our UNIX business, and the factors set forth below in Part II, Item 1A-Risk Factors. We also wish to advise readers not to place any undue reliance on the forward-looking statements contained in this report, which reflect our beliefs and expectations only as of the date of this report. We assume no obligation to update or revise these forward-looking statements to reflect new events or circumstances or any changes in our beliefs or expectations, other than as required by law.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Risk. We have foreign offices and operations in Europe and Asia. As a result, a portion of our revenue is derived from sales to customers outside the United States. Our international revenue is primarily denominated in U.S. dollars, Euros and United Kingdom Pounds. Most of the operating expenses related to our foreign-based operations are denominated in foreign currencies and therefore operating results are affected by changes in the U.S. dollar exchange rate in relation to foreign currencies such as the Euro, among others. If the U.S. dollar weakens compared to the Euro and other currencies, our operating expenses for foreign operations will be higher when translated back into U.S. dollars. Our revenue can also be affected by general economic conditions in the United States, Europe and other international markets. Our results of operations may be affected in the short term by fluctuations in foreign currency exchange rates.

- 28 -

Interest Rate Risk. The primary objective of our cash management strategy is to invest available funds in a manner that assures safety and liquidity and maximizes yield within such constraints. We believe that a hypothetical movement in interest rates, either up or down of up to 2%, would not have a material adverse impact on our cash and cash equivalents and available-for-sale marketable securities. We do not borrow money for short-term investment purposes.

Investment Risk. We have historically invested in equity instruments of privately held and public companies in the technology industry for business and strategic purposes. Investments are accounted for under the cost method if our ownership is less than 20 percent and we are not able to exercise influence over operations. We account for our ownership interests in companies in which we own at least 20% and less than 50% using the equity method of accounting. Under the equity method, we record our portion of the entities’ net income or net loss in our consolidated statements of operations. Our investment policy is to regularly review the assumptions and operating performance of these companies and to record impairment losses when events and circumstances indicate that these investments may be impaired. As of January 31, 2007, we did not hold any cost method investments. As of January 31, 2007, the carrying value of our equity method investment of $431,000 was for our 30% ownership in a Chinese company.

The stock market in general, and the market for shares of technology companies in particular, has experienced price fluctuations. In addition, factors such as new product introductions by our competitors or developments in the SCO Litigation may have a significant impact on the market price of our common stock. Furthermore, quarter-to-quarter fluctuations in our results of operations may have a significant impact on the market price of our common stock. These conditions could cause the price of our common stock to fluctuate substantially over short periods of time.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective.

Changes in internal control over financial reporting. During the most recent fiscal quarter covered by this report, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Certain legal proceedings in which we are involved are discussed in Part I, Item 3, of our Annual Report on Form 10-K for the year ended October 31, 2006. In addition, for more information regarding our legal proceedings, please see Note 3 included in Part 1, Item 1. Unaudited Financial Statements – Notes to Condensed Consolidated Financial Statements, which information is incorporated herein by reference.

- 29 -

ITEM 1A. RISK FACTORS

Investing in our securities involves a high degree of risk. In addition to the other information contained in this Form 10-Q, you should consider the following risk factors before investing in our securities.

We do not have a history of profitable operations and our cash resources are limited.

Our year ended October 31, 2003 was the first full year we were profitable in our operating history. Our profitability for the year ended October 31, 2003 resulted primarily from our SCOsource business. For the years ended October 31, 2006, 2005 and 2004, we incurred net losses applicable to common stockholders of $16,598,000, $10,726,000 and $16,227,000, respectively, and for the three months ended January 31, 2007 we incurred a net loss of $1,024,000. As of January 31, 2007, our accumulated deficit was $252,564,000.

If our revenue from the sale of our UNIX products and services continues to decline, or if we continue to devote significant cash resources to the SCO Litigation, we will need to further reduce operating expenses to generate positive cash flows. During October 2006, we implemented a reduction in force and decreased our ongoing operating expenses in an effort to decrease our total costs. We may not be able to further reduce operating expenses without damaging our ability to support our existing UNIX business. Additionally, we may not be able to achieve profitability through additional cost-cutting actions.

As of January 31, 2007, we had a total of $7,637,000 in cash and cash equivalents and available-for-sale marketable securities and an additional $4,498,000 of restricted cash to be used to pursue the SCO Litigation. Since October 31, 2004, we have spent a total of $11,021,000 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.

We may not prevail in our lawsuits with IBM, Novell and others, which may adversely affect our ability to continue in business.

We continue to pursue the SCO Litigation and believe in the merits of our cases. With respect to our litigation with IBM, both parties are preparing for summary judgment arguments scheduled for March 2007. IBM has filed 6 motions for summary judgment that, if granted in whole or in substantial part, could resolve our claims in IBM’s favor or substantially reduce our claims. We have filed 3 motions for summary judgment. Arguments on the motions were heard in early March 2007. The Court took the matters under advisement and will issue rulings at some point in the future.

On November 29, 2006, the District Court issued a ruling upholding the June 28, 2006 Magistrate Judge’s ruling that removed over 180 (out of 293) of our technology disclosure claims from the case. Additionally, on December 21, 2006, the Magistrate Judge signed an order which held that certain items of technology included in our expert reports go beyond the technology disclosure claims contained in our December 22, 2005 filing. We have filed objections to that order with the District Court. The result of these recent rulings is that we still have over 100 technology disclosure claims from the December 22, 2005 filing in the case with IBM.

With respect to our litigation with Novell, Novell claims it did not sell The Santa Cruz Operation, Inc. the UNIX copyrights and it claims it has the right to waive our claims against UNIX source licensees, such as IBM. Novell has filed a motion for preliminary injunction and a motion for partial summary judgment. We also filed a cross-motion for partial summary judgment. The Court heard arguments on these motions on January 23, 2007, and as of the date

- 30 -

of filing of this Form 10-Q, no ruling had been made. If Novell prevails on its motion, some or all of our cash and cash equivalents could be encumbered.

We can not guarantee whether our claims against IBM or Novell will be heard by a jury. The lawsuits with IBM and Novell will continue to be costly. In the event we are not successful with the IBM or Novell motions, or the continuing litigation requires more cash than expected, our business and operations would be materially harmed.

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. Additionally, the market price of our common stock may be negatively affected as a result of developments in our legal action against IBM that may be, or may be perceived to be, adverse to us.

We must continue to pay for expert, consulting and other expenses through the conclusion of our litigation with IBM and Novell. As we continue with discovery and other trial preparations, we may be required to place additional amounts into the escrow account, which could further reduce our liquidity position.

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 no 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. Although this case is currently stayed pending the resolution of our suit against IBM, we intend to vigorously defend this action. However, if Red Hat is successful in its claim against us, our business and results of operations could be materially harmed.

Our Engagement Agreement with the Law Firms representing us in the SCO Litigation requires us to pay for expert, consulting and other costs, which could harm our liquidity position if these costs are higher than anticipated.

On October 31, 2004, the Company entered into an engagement agreement (the “Engagement Agreement”) with Boies, Schiller & Flexner LLP, Kevin McBride and Berger Singerman (the “Law Firms”). This Engagement Agreement supercedes and replaces the original engagement agreement that was entered into in February 2003. The Engagement Agreement governs the relationship between the Company and the Law Firms in connection with their representation of the Company in the SCO Litigation.

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. During October 2006, we deposited an additional $5,000,000 into the escrow account. In the event that we exhaust these funds, we must 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 further reduce our liquidity position. As of January 31, 2007, we had a total of $7,637,000 in cash and cash equivalents and available-for-sale marketable securities and an additional $4,498,000 of restricted cash to be used to pursue the SCO Litigation. Since October 31, 2004, we have spent a total of $11,021,000 for expert, consulting and other costs and fees as agreed to in the Engagement Agreement with our legal counsel in the SCO Litigation.

- 31 -

Developments in the SCO Litigation and fluctuations in our operating results or the failure of our operating results to meet the expectations of public market analysts and investors may negatively impact our stock price.

Developments in the SCO Litigation and fluctuations in our 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 significantly. Because of the potential for fluctuations in our expenses related to the SCO Litigation in any particular period, you should not rely on comparisons of our results of operations as an indication of future performance.

Factors that may affect our results include:

	•		results of, developments in, or costs of the SCO Litigation as well as adverse publicity regarding our business and the SCO Litigation;

	•		changes in business attitudes toward UNIX as a viable operating system compared to other competing systems, especially Linux;

	•		the outcome of pending motions for summary judgment and a preliminary injunction motion;

	•		changes in general economic conditions, such as recessions, that could affect capital expenditures in the software industry;

	•		the interest level of resellers in recommending our UNIX business solutions to end users and the introduction, development, timing, competitive pricing and market acceptance of our products and services and those of our competitors;

	•		the contingency and other costs we may pay to the Law Firms representing us in our efforts to establish and defend our intellectual property rights;

	•		changes in attitudes of customers and partners due to the decline in our UNIX business and our position against the inclusion of our UNIX code and derivative works in Linux; and

	•		the activities of short sellers.

We also experience fluctuations in operating results in interim periods in Europe and the Asia Pacific regions due to seasonal slowdowns and economic conditions in these areas. Seasonal slowdowns in these regions typically occur during the summer months.

As a result of the factors listed above and elsewhere, it is possible that our results of operations may be below the expectations of public market analysts and investors in any particular period. This could cause our stock price to decline. If revenue falls below our expectations, and we are unable to quickly reduce our spending in response, our operating results will be lower than expected. Our stock price may fall in response to these events.

We operate in a highly competitive market and face significant competition from a variety of current and potential sources; many of our current and potential competitors have greater financial and technical resources than we do; thus, we may fail to compete effectively.

In the operating system market, our competitors include IBM, Red Hat, Novell, Sun, Microsoft, and other UNIX and Linux distributors. These and other competitors are aggressively pursuing the current UNIX operating system market. Many of these competitors have access to substantially greater resources than we do. The major competitive alternative to our UNIX products is Linux. The expansion of our competitors’ offerings may restrict the overall market available for our UNIX products, including some markets where we have been successful in the past.

Our future success may depend in part on our ability to continue to meet the increasing needs of our customers by supporting existing and emerging technologies. If we do not have the

- 32 -

resources to enhance our products to meet these evolving needs, we may not remain competitive and be able to sustain our business. Additionally, because technological advancement in the UNIX operating system market and alternative operating system markets is progressing at an advanced pace, we will have to develop and introduce enhancements to our existing products and any new products on a timely basis to keep pace with these developments, evolving industry standards, changing customer requirements and keeping current on certifications. Our failure to meet any of these and other competitive pressures may render our existing products and services obsolete, which would have an adverse impact on our revenue and operations.

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.

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.

We may lose the support of industry partners leading to an accelerated decline in our UNIX products and services revenue.

The decline in our UNIX business may cause industry partners, developers, customers and hardware and software vendors to choose not to support or certify to our UNIX operating system products. This would lead to an increased decline in our UNIX products and services revenue and would adversely impact our results of operations and liquidity.

We rely on our indirect sales channel for distribution of our products, and any disruption of our channel at any level could adversely affect the sales of our products.

We have a two-tiered distribution channel. The relationships we have developed with resellers allow us to offer our products and services to a much larger customer base than we would otherwise be able to reach through our own direct sales and marketing efforts. Some solution providers also purchase solutions through our resellers, and we anticipate they will continue to do so. Because we usually sell indirectly through resellers, we cannot control the relationships through which resellers, solution providers or equipment integrators purchase our products. In turn, we do not control the presentation of our products to end users. Therefore, our sales could be affected by disruptions in the relationships between us and our resellers, between our resellers and solution providers, or between solution providers and end users. Also, resellers and solution providers may choose not to emphasize our products to their

- 33 -

customers. Any of these occurrences could diminish the effectiveness of our distribution channel and lead to decreased sales.

Our foreign-based operations and sales create special problems, including the imposition of governmental controls and taxes and fluctuations in currency exchange rates that could hurt our results.

We have employees or contractors in certain locations in Europe, the Middle East, Latin America, and Asia. These foreign operations are subject to certain inherent risks, including:

	•		potential loss of developed technology through piracy, misappropriation, or more lenient laws regarding intellectual property protection;

	•		imposition of governmental controls, including trade restrictions and other tax requirements;

	•		fluctuations in currency exchange rates and economic instability;

	•		longer payment cycles for sales in foreign countries; and

	•		seasonal reductions in business activity.

In addition, certain of our operating expenses are denominated in local currencies, creating risk of foreign currency translation losses that could reduce our financial results and cash flows. When we generate profits in foreign countries, our effective income tax rate is increased.

During the three months ended April 30, 2004, our Indian office was assessed withholding taxes by the Government of India Income Tax Department. The Tax Department assessed a 15% withholding tax on certain revenue transactions in India that the Tax Department deemed royalty revenue under the Income Tax Act. We have filed an appeal with the Tax Department and believe that revenue from our packaged software does not qualify for royalty treatment and therefore would not be subject to withholding tax. However, we may be unsuccessful in our appeal against the Tax Department and be obligated to pay the assessed taxable amounts. Because of our international operations, we may be subject to additional withholding or other taxes from other international jurisdictions.

If we are unable to retain key personnel in an intensely competitive environment, our operations could be adversely affected.

We need to retain our key management, technical and support personnel. Competition for qualified professionals in the software industry is intense, and departures of existing personnel could be disruptive to our business and might result in the departure of other employees. During October 2006 we were required to reduce our operating expenses and eliminated certain positions within our worldwide workforce in an effort to reduce operating costs. The loss or departure of any officers or key employees could harm our ability to implement our business plan and could adversely affect our operations. Our future success depends to a significant extent on the continued service and coordination of our management team, particularly Darl C. McBride, our President and Chief Executive Officer.

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

- 34 -

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.

Our stock price is volatile.

The trading price for our common stock has been volatile during the last several years and our share price has changed dramatically over short periods. We believe that changes in our stock price are affected by the factors mentioned above under the caption entitled “Fluctuations in our operating results or the failure of our operating results to meet the expectations of public market analysts and investors may negatively impact our stock price” as well as from changing public perceptions concerning the strength of the SCO Litigation and other factors beyond our control. Public perception can change quickly and without any change or development in our underlying business or litigation position. An investment in our stock is subject to such volatility and, consequently, is subject to significant risk.

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

As of February 28, 2007, we have issued outstanding options to purchase up to approximately 5,369,000 shares of common stock with an average exercise price of $3.82 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 numbers 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 13.4% 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.

Our stock price could decline further because of the activities of short sellers.

Our stock has attracted significant interest from short sellers. The activities of short sellers could further reduce the price of our stock or inhibit increases in our stock price.

- 35 -

The right of our Board of Directors to authorize additional shares of preferred stock could adversely impact the rights of holders of our common stock.

Our Board of Directors currently has the right, with respect to the 5,000,000 shares of our preferred stock, to authorize the issuance of one or more additional series of our preferred stock with such voting, dividend and other rights as our directors determine. The Board of Directors can designate new series of preferred stock without the approval of the holders of our common stock. The rights of holders of our common stock may be adversely affected by the rights of any holders of additional shares of preferred stock that may be issued in the future, including without limitation, further dilution of the equity ownership percentage of our holders of common stock and their voting power if we issue preferred stock with voting rights. Additionally, the issuance of preferred stock could make it more difficult for a third party to acquire a majority of our outstanding voting stock.

Our stockholder rights plan could make it more difficult for a hostile bid for our company or a change of control transaction to succeed at current market prices for our stock.

We have adopted a stockholder rights plan. The power given to the Board of Directors by the stockholder rights plan may make it more difficult for a change of control of our company to occur or for our company to be acquired if the acquisition is opposed by our Board of Directors.

ITEM 6. EXHIBITS

(a)

Exhibits

	3.1		Amended and Restated Certificate of Incorporation of Caldera International, Inc. (incorporated by reference to Exhibit 3.1 to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).

	3.2		Certificate of Amendment to Amended and Restated Certificate of Incorporation regarding consolidation of outstanding shares (incorporated by reference to Exhibit 3.2 to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).

	3.3		Certificate of Amendment to Amended and Restated Certificate of Incorporation regarding change of name to The SCO Group, Inc. (incorporated by reference to Exhibit 3.3 to SCO’s Registration Statement on Form 8A12G/A (File No. 000-29911)).

	3.4		Amended and Restated Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).

	3.5		Certificate of Designation for Series A-1 Convertible Preferred Stock (incorporated by reference to Exhibit 4.1 to SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No. 000-29911)).

	3.6		Certificate of Correction correcting the Certificate of Designation for Series A-1 Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No. 000-29911)).

	31.1		Certification of Darl C. McBride, President and Chief Executive Officer, pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

- 36 -

	31.2		Certification of Bert B. Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

	32.1		Certification of Darl C. McBride, President and Chief Executive Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	32.2		Certification of Bert B. Young, Chief Financial Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

ITEM 7. SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


Date: March 16, 2007	THE SCO GROUP, INC.
	By:	/s/ Bert B. Young
		Bert B. Young
		Duly Authorized Officer and Chief Financial Officer (Principal Financial and Accounting Officer)

- 37 -

EXHIBIT INDEX


Exhibit
Number		Exhibit Description

3.1		Amended and Restated Certificate of Incorporation of Caldera International, Inc. (incorporated by reference to Exhibit 3.1 to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).

3.2		Certificate of Amendment to Amended and Restated Certificate of Incorporation regarding consolidation of outstanding shares (incorporated by reference to Exhibit 3.2 to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).

3.3		Certificate of Amendment to Amended and Restated Certificate of Incorporation regarding change of name to The SCO Group, Inc. (incorporated by reference to Exhibit 3.3 to SCO’s Registration Statement on Form 8A12G/A (File No. 000-29911)).

3.4		Amended and Restated Bylaws (incorporated by reference to Exhibit 3.4 to SCO’s Registration Statement on Form 8-A12G/A (File No. 000-29911)).

3.5		Certificate of Designation for Series A-1 Convertible Preferred Stock (incorporated by reference to Exhibit 4.1 to SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No. 000-29911)).

3.6		Certificate of Correction correcting the Certificate of Designation for Series A-1 Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to SCO’s Current Report on Form 8-K filed on February 9, 2004 (File No. 000-29911)).

31.1		Certification of Darl C. McBride, President and Chief Executive Officer, pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Bert Young, Chief Financial Officer, pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Darl C. McBride, President and Chief Executive Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Bert Young, Chief Financial Officer, pursuant to Section 1350, Chapter 63 of Title 18, United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

- 38 -

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents


		Page
		Number
PART I.	FINANCIAL INFORMATION
Item 1.	Unaudited Financial Statements
	Condensed Consolidated Balance Sheets as of January 31, 2007 and October 31, 2006	3
	Condensed Consolidated Statements of Operations and Comprehensive Loss for the three months ended January 31, 2007 and 2006	4
	Condensed Consolidated Statements of Cash Flows for the three months ended January 31, 2007 and 2006	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	28
Item 4.	Controls and Procedures	29
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	29
Item 1A.	Risk Factors	30
Item 6.	Exhibits	36
	Signatures	37
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2