UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark one)

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

For the quarterly period ended July 31, 2006

OR

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

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 x  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  x

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 x

As of September 11, 2006, there were 21,093,981 shares of the Registrant’s common stock, $0.001 par value per share, outstanding.

The SCO Group, Inc.

Table of Contents

PART I.	FINANCIAL INFORMATION
Item 1.	Unaudited Financial Statements
	Condensed Consolidated Balance Sheets as of July 31, 2006 and October 31, 2005
	Condensed Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended July 31, 2006 and 2005
	Condensed Consolidated Statements of Cash Flows for the nine months ended July 31, 2006 and 2005
	Notes to Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings
Item 1A.	Risk Factors
Item 6.	Exhibits
	Signatures

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PART I	FINANCIAL INFORMATION
ITEM 1.	UNAUDITED FINANCIAL STATEMENTS

THE SCO GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

	July 31, 2006			October 31, 2005
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	8,861		$	4,272
Restricted cash	2,010			5,690
Available-for-sale marketable securities	5,099			6,165
Accounts receivable, net of allowance for doubtful accounts of $97 and $144, respectively	4,072			6,343
Other	1,720			2,454
Total current assets	21,762			24,924
PROPERTY AND EQUIPMENT:
Computer and office equipment	2,184			2,224
Leasehold improvements	316			345
Furniture and fixtures	79			96
	2,579			2,665
Less accumulated depreciation and amortization	(1,969		)	(2,087		)
Net property and equipment	610			578
OTHER ASSETS:
Definite-lived intangibles, net	677			2,707
Other	423			739
Total other assets	1,100			3,446
Total assets	$	23,472		$	28,948
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	2,239		$	2,197
Payable to Novell, Inc.	449			2,815
Accrued payroll and benefits	1,734			2,656
Accrued liabilities	3,087			3,118
Deferred revenue	2,875			3,841
Royalties payable	272			406
Income taxes payable	1,235			1,222
Total current liabilities	11,891			16,255
LONG-TERM LIABILITIES	227			338
COMMITMENTS AND CONTINGENCIES (Note 4)
COMMON STOCK SUBJECT TO RESCISSION (Note 5)	—			1,018
STOCKHOLDERS’ EQUITY:
Common stock, $0.001 par value; 45,000 shares authorized, 21,391 and 18,331 shares outstanding, respectively	21			18
Additional paid-in capital	259,780			246,985
Common stock held in treasury; 297 and 290 shares, respectively	(2,446		)	(2,414		)
Warrants outstanding	856			856
Accumulated other comprehensive income	940			834
Accumulated deficit	(247,797		)	(234,942		)
Total stockholders’ equity	11,354			11,337
Total liabilities and stockholders’ equity	$	23,472		$	28,948

See accompanying notes to condensed consolidated financial statements.

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THE SCO GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(in thousands, except per share data)

	Three Months Ended July 31,						Nine Months Ended July 31,
	2006			2005			2006			2005
REVENUE:
Products	$	6,201		$	7,953		$	17,904		$	23,095
SCOsource licensing	31			32			95			132
Services	1,189			1,368			3,891			4,249
Total revenue	7,421			9,353			21,890			27,476
COST OF REVENUE:
Products	478			695			1,559			1,902
SCOsource licensing	2,315			3,085			10,087			9,467
Services	666			700			2,012			2,195
Total cost of revenue	3,459			4,480			13,658			13,564
GROSS MARGIN	3,962			4,873			8,232			13,912
OPERATING EXPENSES:
Sales and marketing	3,111			2,935			8,656			8,849
Research and development	2,029			1,940			5,786			6,145
General and administrative	1,829			1,647			5,139			5,446
Amortization of intangibles	593			593			1,778			1,779
Total operating expenses	7,562			7,115			21,359			22,219
LOSS FROM OPERATIONS	(3,600		)	(2,242		)	(13,127		)	(8,307		)
EQUITY IN INCOME (LOSS) OF AFFILIATE	—			(19		)	(8		)	51
OTHER INCOME, NET:
Interest income	191			122			542			257
Other income (expense), net	(64		)	(149		)	46			1,025
Total other income (expense), net	127			(27		)	588			1,282
LOSS BEFORE PROVISION FOR INCOME TAXES	(3,473		)	(2,288		)	(12,547		)	(6,974		)
PROVISION FOR INCOME TAXES	(107		)	(84		)	(308		)	(321		)
NET LOSS	$	(3,580	)	$	(2,372	)	$	(12,855	)	$	(7,295	)
BASIC AND DILUTED NET LOSS PER COMMON SHARE	$	(0.17	)	$	(0.13	)	$	(0.62	)	$	(0.41	)
WEIGHTED AVERAGE BASIC AND DILUTED COMMON SHARES OUTSTANDING	21,063			17,993			20,703			17,885
OTHER COMPREHENSIVE LOSS:
Net loss	$	(3,580	)	$	(2,372	)	$	(12,855	)	$	(7,295	)
Unrealized gain on available-for-sale marketable securities	4			5			49			14
Foreign currency translation adjustment	37			(128		)	57			(124		)
COMPREHENSIVE LOSS	$	(3,539	)	$	(2,495	)	$	(12,749	)	$	(7,405	)

See accompanying notes to condensed consolidated financial statements.

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THE SCO GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

	Nine Months Ended July 31,
	2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(12,855	)	$	(7,295	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization of intangibles (including $252 and $251 classified as cost of SCOsource licensing revenue)	2,030			2,030
Depreciation and amortization	226			271
Stock-based compensation	1,323			22
Loss on disposal of assets	8			32
Equity in (income) loss of affiliate	8			(51		)
Changes in operating assets and liabilities:
Restricted cash	1,314			1,421
Accounts receivable, net	2,271			1,691
Other current assets	734			(506		)
Other assets	—			31
Accounts payable	42			(6,517		)
Accrued payroll and benefits	(922		)	(1,099		)
Compensation to law firms	—			(7,956		)
Accrued liabilities	(31		)	(676		)
Deferred revenue	(966		)	(856		)
Royalties payable	(134		)	(43		)
Income taxes payable	13			44
Long-term liabilities	(111		)	(3		)
Net cash used in operating activities	(7,050		)	(19,460		)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment	(265		)	(233		)
Dividend received	308			—
Purchase of available-for-sale marketable securities	(6,441		)	(8,224		)
Proceeds from sale of available-for-sale marketable securities	7,507			20,904
Net cash provided by investing activities	1,109			12,447
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sale of common stock through employee stock purchase plan	613			720
Proceeds from exercise of common stock options	35			235
Repurchase of common stock	(32		)	—
Proceeds from sale of common stock in a private placement, net of offering costs	9,809			—
Net cash provided by financing activities	10,425			955
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS	4,484			(6,058		)
EFFECT OF FOREIGN EXCHANGE RATES ON CASH AND CASH EQUIVALENTS	105			(109		)
CASH AND CASH EQUIVALENTS, beginning of period	4,272			12,693
CASH AND CASH EQUIVALENTS, end of period	$	8,861		$	6,526
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for income taxes	$	247		$	259
SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES:
Increase (decrease) in common stock subject to rescission	$	(1,018	)	$	576

See accompanying notes to condensed consolidated financial statements.

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

(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 and nine months ended July 31, 2006 are not necessarily indicative of the operating results that may be expected for the year ending October 31, 2006.

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, among others, revenue recognition, allowances for

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doubtful accounts 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.

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 compliance 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.

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Cash and Cash Equivalents

The Company considers all investments purchased with original maturities of three months or less to be cash equivalents.  Cash equivalents were $4,986,000 and $1,528,000 as of July 31, 2006 and October 31, 2005, respectively.  Cash was $3,875,000 and $2,744,000 as of July 31, 2006 and October 31, 2005, respectively.

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 $5,099,000 as of July 31, 2006.  Any available-for-sale marketable securities in an unrealized loss position as of July 31, 2006 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 earnings and establishes a new basis for the security.

Net Loss per Common Share

Basic net loss per common share (“Basic EPS”) is computed by dividing net loss by the weighted average number of common shares outstanding.  Diluted net income per common share (“Diluted EPS”), if any, is computed by dividing net income 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 5,080,000 and 3,982,000 for the three and nine months ended July 31, 2006 and 2005, respectively, are not included in the calculation of diluted net loss per common share because they are anti-dilutive.

(3) DEFINITE-LIVED INTANGIBLE ASSETS

The following table presents the activity related to definite-lived intangible assets for the nine months ended July 31, 2006 as well as the remaining unamortized balances as of July 31, 2006:

	Carrying Value as of October 31, 2005		Amortization Expense for the Nine Months  Ended July 31, 2006			Carrying Value as of July 31, 2006
Definite-lived intangible assets:
Distribution/reseller channel	$	2,318,000	$	(1,739,000	)	$	579,000
Acquired technology	337,000		(252,000		)	85,000
Trade name	52,000		(39,000		)	13,000
Total definite-lived intangible assets	$	2,707,000	$	(2,030,000	)	$	677,000

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Of the $2,030,000 in amortization expense for the nine months ended July 31, 2006, $1,778,000 was classified as amortization of intangible assets in operating expenses and the remaining $252,000 was classified as cost of SCOsource licensing revenue.

(4) COMMITMENTS AND CONTINGENCIES

Litigation

IBM Corporation

On or about March 6, 2003, the Company filed a civil complaint against IBM 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, among other things, 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.  As a result of IBM’s actions, the Company is requesting 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 IBM’s UNIX source code license agreement, which underlies IBM’s 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 nine causes of action that are similar to those set forth above, adds a new claim for copyright infringement and removes the claim for misappropriation of trade secrets.  IBM 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 February 9, 2005, the court denied three motions for partial summary judgment that IBM had filed on the Company’s contract claims, on IBM’s eighth counterclaim for copyright infringement, and on IBM’s tenth counterclaim for a declaration of non-infringement of the Company’s copyrights.  The court denied each of those motions without prejudice to IBM’s renewing or refiling the motions after discovery is complete.  The court also denied the Company’s motion to stay or dismiss IBM’s tenth counterclaim.  The court ordered that no further dispositive motions could be filed until the close of discovery.

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On July 1, 2005, the court issued a revised Scheduling Order establishing, among other things, discovery and motion deadlines over the next 18 months with a five-week jury trial to commence on February 26, 2007.

Pursuant to the court’s July 1, 2005 Scheduling Order, the Company filed its Interim Disclosure of Material Misused by IBM on October 28, 2005.  The Company’s report included a matrix that identified 217 separate technology disclosures that it contends IBM improperly made to enhance Linux in violation of one or more contractual prohibitions governing IBM’s use of the Company’s proprietary material.  The Company continued to review relevant materials, including evidence IBM has produced in discovery, and filed an updated report on December 22, 2005 detailing IBM’s misuse of the Company’s proprietary material.  The Company’s December 22, 2005 report included 294 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.  IBM argues that of the 294 items identified by the Company in the December 22, 2005 filing, 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 22, 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 Company’s technology disclosures from the case.  Although this ruling is a significant limitation of the number of technology disclosures the Company challenged in its December 22, 2005 filing, it also means that over 100 of our 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 challenge the process and the result embodied in the Magistrate Judge’s order and the Company expects a hearing to be set in the near future.

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 22, 2005 submission to the court and that those expert reports should be stricken to that extent.  No hearing has been set on that motion and no ruling has been made.  The Company believes that the motion lacks merit and has filed its opposition to the motion.

Both parties have filed expert reports and expert discovery is under way.

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, prevent Novell from representing any ownership interest in those copyrights and require Novell to retract or withdraw all representations it has made regarding its purported ownership of those copyrights and UNIX itself.

Novell has 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

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Purchase Agreement between Novell and the Company’s predecessor-in-interest, The Santa Cruz Operation, Inc., 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 December 6, 2005, a scheduling order was entered by the court setting a schedule of discovery and motions leading up to a trial in June 2007.  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 has 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 May 26, 2006, the Company filed a response to Novell’s motion to stay, and on June 27, 2006, we responded to Novell’s request for arbitration.  On August 21, 2006, the court ordered that the claims relating to the SuSE arbitration should be stayed but the other claims in the case should proceed.

The three-person arbitration panel has been selected for the SuSE arbitration in Switzerland, and that process will be commencing in the near future.  The Company does not yet know the schedule of the proceedings.

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.

The plaintiffs, the issuers and the insurance companies have negotiated an agreement to settle the dispute between the plaintiffs and the issuers.  All parties, including the plaintiffs, issuers and insurance companies, have executed this settlement agreement and the settlement agreement has been submitted to the court for approval.  If 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 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

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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 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 or financial position.

(5) COMMON STOCK SUBJECT TO RESCISSION

The Company believes certain shares and options granted under its Equity Compensation Plans were issued without complying with registration or qualification requirements under federal securities laws and the securities laws of certain states.  As a result, certain Plan participants had a right to rescind their purchases of shares under the Plans or recover damages if they no longer own the shares or hold unexercised options, subject to applicable statutes of limitations.  Additionally, regulatory authorities may require the Company to pay fines or impose other sanctions.

Accounting Series Release (“ASR”) No. 268 and Emerging Issues Task Force (“EITF”) Topic D-98 require stock subject to rescission or redemption requirements outside the control of the Company to be classified outside of permanent equity.  The exercise of the rescission right is at the holders’ discretion, but exercise of that right may depend in part on the fair value of the Company’s common stock, which is outside of the Company’s and the holders’ control.  Consequently, common stock subject to rescission is classified as temporary equity.

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In December 2005, the Company offered to rescind a total of 337,289 shares of common stock issued under its 2000 Employee Stock Purchase Plan (the “ESPP”) to current and former employees while they resided in any of California, Connecticut, Illinois, New Jersey, Utah, Texas or Washington.  These shares represented all of the ESPP shares the Company issued to residents of these states for which a purchaser could claim a rescission right.  The rescission offer was intended to address the Company’s rescission liability relating to its federal and state securities laws compliance issues by allowing the holders of the shares covered by the rescission offer to rescind the underlying securities transactions and sell those securities back to the Company or recover damages, as the case may be.

The rescission offer concluded on January 20, 2006.  As of that date, 14 offerees accepted the Company’s offer to rescind the purchase of approximately 7,300 shares.  The Company made aggregate payments to such offerees of approximately $41,500, which included approximately $31,800 for the purchase of the shares and approximately $9,700 in statutory interest and damages.  As a result of the rescission offer, the Company believes it has extinguished its state rescission liability and mitigated its federal rescission liability to anyone to whom the rescission offer was made for noncompliance with the registration or qualification requirements of federal and state securities laws as they relate to the shares issued under the ESPP.  Upon the close of the rescission offer, the Company reclassified the remainder of the common stock subject to rescission which totaled $1,018,000 as additional paid-in capital in permanent equity.

(6) 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.

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The Company has also established the ESPP, 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.

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 requires 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 and nine months ended July 31, 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)).  In accordance with the modified prospective application method, results for the three and nine months ended July 31, 2005 have not been restated.

The effect of accounting for stock-based awards under SFAS No. 123(R) for the three and nine months ended July 31, 2006 was to record $490,000 and $1,323,000, respectively, of stock-based compensation expense.  For the three and nine months ended July 31, 2006 and 2005, the Company has allocated stock-based compensation expense to the following statement of operations captions:

	Three Months Ended July 31,				Nine Months Ended July 31,
	2006		2005		2006		2005
Cost of products	$	5,000	$	—	$	12,000	$	—
Cost of SCOsource licensing	61,000		—		171,000		—
Cost of services	17,000		—		46,000		—
Sales and marketing	102,000		—		261,000		14,000
Research and development	41,000		—		97,000		8,000
General and administrative	264,000		—		736,000		—
Total stock-based compensation	$	490,000	$	—	$	1,323,000	$	22,000

The following pro-forma information, as required by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123,” is presented for comparative purposes and illustrates the effect on net loss and net loss per common share for the three and nine months ended July 31, 2005 as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation prior to November 1, 2005:

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	Three Months Ended July 31, 2005			Nine Months Ended July 31, 2005
Net loss:
As reported	$	(2,372,000	)	$	(7,295,000	)
Stock-based compensation included in reported net loss	—			22,000
Stock-based compensation under fair value method	(569,000		)	(1,166,000		)
Pro forma net loss	$	(2,941,000	)	$	(8,439,000	)
Net loss per basic and diluted common share:
As reported	$	(0.13	)	$	(0.41	)
Pro forma	$	(0.16	)	$	(0.47	)

With respect to stock options granted during the three and nine months ended July 31, 2006 and 2005, the assumptions used in the Black-Scholes option-pricing model are as follows: 

	Three Months Ended July 31,				Nine Months Ended July 31,
	2006		2005		2006		2005
Risk-free interest rate	5.0	%	4.1	%	4.8	%	3.7	%
Expected dividend yield	0.0	%	0.0	%	0.0	%	0.0	%
Volatility	66.2	%	47.1	%	63.4	%	65.0	%
Expected exercise life (in years)	5.0		2.7		5.0		2.7

The estimated fair value of stock options and ESPP shares are amortized over the vesting period of the award.

During the nine months ended July 31, 2006, the Company granted options to purchase approximately 1,065,000 shares of common stock with an average exercise price of $3.84 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 nine months ended July 31, 2006, options to purchase approximately 29,000 shares of common stock were exercised with an average exercise price of $1.21 per share.  As of July 31, 2006, there were approximately 4,845,000 stock options outstanding with a weighted average exercise price of $4.11 per share.

 (7) CONCENTRATION OF CREDIT RISK

As of July 31, 2006 and October 31, 2005, the Company had no customers who made up more than 10 percent of the accounts receivable balance.

During the three and nine months ended July 31, 2006 and 2005, no single customer accounted for more than 10 percent of total revenue.

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(8) 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 develops, sells and distributes UNIX server and mobile 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 July 31, 2006
	UNIX			SCOsource			Total
Revenue	$	7,390,000		$	31,000		$	7,421,000
Cost of revenue	1,144,000			2,315,000			3,459,000
Gross margin (deficit)	6,246,000			(2,284,000		)	3,962,000
Sales and marketing	3,111,000			—			3,111,000
Research and development	1,932,000			97,000			2,029,000
General and administrative	1,781,000			48,000			1,829,000
Amortization of intangibles	593,000			—			593,000
Total operating expenses	7,417,000			145,000			7,562,000
Loss from operations	$	(1,171,000	)	$	(2,429,000	)	$	(3,600,000	)

	Three Months Ended July 31, 2005
	UNIX		SCOsource			Total
Revenue	$	9,321,000	$	32,000		$	9,353,000
Cost of revenue	1,395,000		3,085,000			4,480,000
Gross margin (deficit)	7,926,000		(3,053,000		)	4,873,000
Sales and marketing	2,935,000		—			2,935,000
Research and development	1,843,000		97,000			1,940,000
General and administrative	1,556,000		91,000			1,647,000
Amortization of intangibles	593,000		—			593,000
Total operating expenses	6,927,000		188,000			7,115,000
Income (loss) from operations	$	999,000	$	(3,241,000	)	$	(2,242,000	)

	Nine Months Ended July 31, 2006
	UNIX			SCOsource			Total
Revenue	$	21,795,000		$	95,000		$	21,890,000
Cost of revenue	3,571,000			10,087,000			13,658,000
Gross margin (deficit)	18,224,000			(9,992,000		)	8,232,000
Sales and marketing	8,655,000			1,000			8,656,000
Research and development	5,501,000			285,000			5,786,000
General and administrative	4,994,000			145,000			5,139,000
Amortization of intangibles	1,778,000			—			1,778,000
Total operating expenses	20,928,000			431,000			21,359,000
Loss from operations	$	(2,704,000	)	$	(10,423,000	)	$	(13,127,000	)

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	Nine Months Ended July 31, 2005
	UNIX		SCOsource			Total
Revenue	$	27,344,000	$	132,000		$	27,476,000
Cost of revenue	4,097,000		9,467,000			13,564,000
Gross margin (deficit)	23,247,000		(9,335,000		)	13,912,000
Sales and marketing	8,695,000		154,000			8,849,000
Research and development	5,846,000		299,000			6,145,000
General and administrative	5,094,000		352,000			5,446,000
Amortization of intangibles	1,779,000		—			1,779,000
Total operating expenses	21,414,000		805,000			22,219,000
Income (loss) from operations	$	1,833,000	$	(10,140,000	)	$	(8,307,000	)

Intangible assets, which consist of the Company’s reseller channel, trade name and technology, have been assigned to the Company’s UNIX and SCOsource segments and consist of the following as of July 31, 2006 and October 31, 2005:

	July 31, 2006		October 31, 2005
Intangible assets:
UNIX (reseller channel and trade name)	$	592,000	$	2,370,000
SCOsource (UNIX technology)	85,000		337,000
Total intangible assets	$	677,000	$	2,707,000

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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, 2005 filed with the Securities and Exchange Commission and management’s discussion and analysis contained therein.  All information presented herein is based on the three and nine months ended July 31, 2006 and 2005.  We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

Overview

Historical Background.  We originally incorporated as Caldera Systems, Inc., a Utah corporation (“Caldera Systems”), on August 21, 1998, and reincorporated as a Delaware corporation on March 6, 2000.  In March 2000, we completed an initial public offering of our common stock.  On May 7, 2001, we formed a new holding company in Delaware under the name of Caldera International, Inc. (“Caldera International”) to acquire substantially all of the assets and operations of the server and professional services groups of The Santa Cruz Operation.  In connection with this acquisition, Caldera Systems became a wholly owned subsidiary of Caldera International.  Former holders of shares and options to purchase shares of Caldera Systems received an equal number of shares and options to purchase shares in Caldera International.  On May 16, 2003, our stockholders approved our corporate name change to The SCO Group, Inc.

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 operating systems and software products to power computers running on Intel architecture.  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 operations 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 companies through their information technology or purchasing departments with our area sales managers 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 fiscal years have been primarily to pre-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.

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The following table shows the operating results of the UNIX business for the three and nine months ended July 31, 2006 and 2005:

	Three Months Ended July 31,
	2006			2005
Revenue	$	7,390,000		$	9,321,000
Cost of revenue	1,144,000			1,395,000
Gross margin	6,246,000			7,926,000
Sales and marketing	3,111,000			2,935,000
Research and development	1,932,000			1,843,000
General and administrative	1,781,000			1,556,000
Amortization of intangibles	593,000			593,000
Total operating expenses	7,417,000			6,927,000
Income (loss) from operations	$	(1,171,000	)	$	999,000

	Nine Months Ended July 31,
	2006			2005
Revenue	$	21,795,000		$	27,344,000
Cost of revenue	3,571,000			4,097,000
Gross margin	18,224,000			23,247,000
Sales and marketing	8,655,000			8,695,000
Research and development	5,501,000			5,846,000
General and administrative	4,994,000			5,094,000
Amortization of intangibles	1,778,000			1,779,000
Total operating expenses	20,928,000			21,414,000
Income (loss) from operations	$	(2,704,000	)	$	1,833,000

Revenue from our UNIX business decreased by $1,931,000, or 21%, for the three months ended July 31, 2006 compared to the three months ended July 31, 2005 and decreased by $5,549,000, or 20%, for the nine months ended July 31, 2006 compared to the nine months ended July 31, 2005.  The revenue from this business has been declining over the last several periods primarily as a result of increased competition from alternative operating systems, particularly Linux.  We believe the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX business because users of Linux generally do not pay for the operating system itself, but pay for services and maintenance.  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 increased from $6,927,000 for the three months ended July 31, 2005 to $7,417,000 for the three months ended July 31, 2006 and this increase was primarily attributable to stock-based compensation as a result of our adoption of SFAS No. 123 (R).  Operating costs decreased slightly from $21,414,000 for the nine months ended July 31, 2005 to $20,928,000 for the nine months ended July 31, 2006 and was primarily attributable to reduced headcount and related costs offset by an increase in stock-based compensation.

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

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

The following table shows the operating results of the SCOsource business for the three and nine months ended July 31, 2006 and 2005 (in thousands):

	Three Months Ended July 31,
	2006			2005
Revenue	$	31,000		$	32,000
Cost of revenue	2,315,000			3,085,000
Gross deficit	(2,284,000		)	(3,053,000		)
Research and development	97,000			97,000
General and administrative	48,000			91,000
Total operating expenses	145,000			188,000
Loss from operations	$	(2,429,000	)	$	(3,241,000	)

	Nine Months Ended July 31,
	2006			2005
Revenue	$	95,000		$	132,000
Cost of revenue	10,087,000			9,467,000
Gross deficit	(9,992,000		)	(9,335,000		)
Sales and marketing	1,000			154,000
Research and development	285,000			299,000
General and administrative	145,000			352,000
Total operating expenses	431,000			805,000
Loss from operations	$	(10,423,000	)	$	(10,140,000	)

Revenue from our SCOsource business decreased slightly from $32,000 for the three months ended July 31, 2005 to $31,000 for the three months ended July 31, 2006 and decreased from $132,000 for the nine months ended July 31, 2005 to $95,000 for the nine months ended July 31, 2006.  Revenue in the above mentioned periods was primarily attributable to sales of our SCOsource IP agreements.

Cost of revenue, which primarily includes legal and professional fees incurred in connection with the SCO Litigation, decreased from $3,085,000 for the three months ended July

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31, 2005 to $2,315,000 for the three months ended July 31, 2006.  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), offset by increases in legal services provide by technical, industry, damage and other experts in connection with the SCO Litigation.  Cost of revenue increased from $9,467,000 for the nine months ended July 31, 2005 to $10,087,000 for the nine months ended July 31, 2006.  This increase was primarily attributable to significant work performed by technical, damage and industry experts and other consultants in connection with the SCO Litigation during the nine months ended July 31, 2006, offset by a reduction in expense associated with the quarterly payments made to the Law Firms as only two quarterly payments were made during the nine months ended July 31, 2006 as compared to three quarterly payments made during the nine months ended July 31, 2005.  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, we are unable to estimate the amount and timing of future SCOsource licensing revenue.  We are unlikely to generate significant revenue from our SCOsource business unless and until we prevail in our SCO Litigation.  Additionally, the success of the SCOsource business may depend 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 tax assets and related valuation allowances;

·Litigation reserves;

·Impairment and useful lives of long-lived assets; and

·Allowances for doubtful accounts receivable.

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

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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.

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.

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 $69,239,000 against our entire net deferred income tax assets as of October 31, 2005.  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 quarterly report on Form 10-Q.  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 changes in future periods, we may be required to record a liability for an adverse outcome, which could have a material adverse effect on our results of operations and financial position.

Impairment and Useful Lives of Long-lived Assets.  We review our long-lived tangible and intangible assets for impairment when events or changes in circumstances indicate that the carrying value of an asset may not be recoverable.  We evaluate, at each balance sheet date, whether events and circumstances have occurred which indicate possible impairment.  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.

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Write-downs of intangible assets may be necessary if the future fair value of these assets is less than 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 expected collectibility of all accounts receivable and apply these policies consistently.  Our allowance for doubtful accounts receivable, which is determined based on our historical experience and a specific review of customer balances, was $97,000 as of July 31, 2006.  Our past experience has resulted in minimal 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 and nine months ended July 31, 2006 and 2005:

	Three Months Ended July 31,						Nine Months Ended July 31,
Statement of Operations Data:	2006			2005			2006			2005
Revenue:
Products	$	6,201,000		$	7,953,000		$	17,904,000		$	23,095,000
SCOsource licensing	31,000			32,000			95,000			132,000
Services	1,189,000			1,368,000			3,891,000			4,249,000
Total revenue	7,421,000			9,353,000			21,890,000			27,476,000
Cost of revenue:
Products	478,000			695,000			1,559,000			1,902,000
SCOsource licensing	2,315,000			3,085,000			10,087,000			9,467,000
Services	666,000			700,000			2,012,000			2,195,000
Total cost of revenue	3,459,000			4,480,000			13,658,000			13,564,000
Gross margin	3,962,000			4,873,000			8,232,000			13,912,000
Operating expenses:
Sales and marketing	3,111,000			2,935,000			8,656,000			8,849,000
Research and development	2,029,000			1,940,000			5,786,000			6,145,000
General and administrative	1,829,000			1,647,000			5,139,000			5,446,000
Amortization of intangibles	593,000			593,000			1,778,000			1,779,000
Total operating expenses	7,562,000			7,115,000			21,359,000			22,219,000
Loss from operations	(3,600,000		)	(2,242,000		)	(13,127,000		)	(8,307,000		)
Equity in income (loss) of affiliate	—			(19,000		)	(8,000		)	51,000
Other income (expense), net	127,000			(27,000		)	588,000			1,282,000
Provision for income taxes	(107,000		)	(84,000		)	(308,000		)	(321,000		)
Net loss	$	(3,580,000	)	$	(2,372,000	)	$	(12,855,000	)	$	(7,295,000	)

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THREE AND NINE MONTHS ENDED JULY 31, 2006 AND 2005

Revenue

	Three Months Ended July 31,
	2006		Change		2005
Revenue	$	7,421,000	(21	)%	$	9,353,000

	Nine Months Ended July 31,
	2006		Change		2005
Revenue	$	21,890,000	(20	)%	$	27,476,000

Revenue for the three months ended July 31, 2006 decreased by $1,932,000, or 21%, from the three months ended July 31, 2005, and revenue for the nine months ended July 31, 2006 decreased by $5,586,000, or 20%, from the nine months ended July 31, 2005.  These decreases were 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 July 31,
	2006			Change		2005
UNIX revenue	$	7,390,000		(21	)%	$	9,321,000
Percent of total revenue	100		%			100		%
SCOsource revenue	31,000			(3	)%	32,000
Percent of total revenue	0		%			0		%

	Nine Months Ended July 31,
	2006			Change		2005
UNIX revenue	$	21,795,000		(20	)%	$	27,344,000
Percent of total revenue	100		%			100		%
SCOsource revenue	95,000			(28	)%	132,000
Percent of total revenue	0		%			0		%

The decrease in revenue in the UNIX business of $1,931,000, or 21%, for the three months ended July 31, 2006 compared to the three months ended July 31, 2005 and the decrease in revenue of $5,549,000, or 20%, for the nine months ended July 31, 2006 compared to the nine months ended July 31, 2005 was primarily attributable to continued competition from other operating systems, particularly Linux.  We anticipate that for the remainder of the year ending October 31, 2006 our UNIX business and the related revenue from the UNIX business will face significant competition from Linux and other operating systems.

Sales of our UNIX products and services during the three and nine months ended July 31, 2006 were primarily to pre-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 decrease if we are not successful with our existing customers or if we lose the support of any of our existing hardware and software vendors or our key industry partners withdraw their marketing and certification support or direct their support to our competitors.

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Products Revenue

	Three Months Ended July 31,
	2006			Change		2005
Products revenue	$	6,201,000		(22	)%	$	7,953,000
Percent of total revenue	84		%			85		%

	Nine Months Ended July 31,
	2006			Change		2005
Products revenue	$	17,904,000		(22	)%	$	23,095,000
Percent of total revenue	82		%			84		%

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 $1,752,000, or 22%, for the three months ended July 31, 2006 compared to the three months ended July 31, 2005 and the decrease in products revenue of $5,191,000, or 22%, for the nine months ended July 31, 2006 compared to the nine months ended July 31, 2005 were 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:

	Three Months Ended July 31,
	2006			Change		2005
OpenServer revenue	$	3,184,000		(26	)%	$	4,309,000
Percent of products revenue	51		%			54		%
UnixWare revenue	2,592,000			24	%	2,085,000
Percent of products revenue	42		%			26		%
Other products revenue	425,000			(73	)%	1,559,000
Percent of products revenue	7		%			20		%

	Nine Months Ended July 31,
	2006			Change		2005
OpenServer revenue	$	10,176,000		(22	)%	$	12,987,000
Percent of products revenue	57		%			56		%
UnixWare revenue	5,901,000			(11	)%	6,606,000
Percent of products revenue	33		%			29		%
Other products revenue	1,827,000			(48	)%	3,502,000
Percent of products revenue	10		%			15		%

The decrease in revenue for OpenServer for the three and nine months ended July 31, 2006 compared to the three and nine months ended July 31, 2005 is primarily the result of continued competition from other operating systems, particularly Linux.  The increase in UnixWare revenue for the three months ended July 31, 2006 compared to the three months ended

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July 31, 2005 is primarily the result of increased sales to end-user customers.  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 July 31,
	2006		Change		2005
SCOsource licensing revenue	$	31,000	(3	)%	$	32,000

	Nine Months Ended July 31,
	2006		Change		2005
SCOsource licensing revenue	$	95,000	(28	)%	$	132,000

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 $32,000 for the three months ended July 31, 2005 compared to $31,000 for the three months ended July 31, 2006 and SCOsource licensing revenue was $132,000 for the nine months ended July 31, 2005 compared to $95,000 for the nine months ended July 31, 2006.  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 July 31,
	2006			Change		2005
Services revenue	$	1,189,000		(13	)%	$	1,368,000
Percent of total revenue	16		%			15		%

	Nine Months Ended July 31,
	2006			Change		2005
Services revenue	$	3,891,000		(8	)%	$	4,249,000
Percent of total revenue	18		%			16		%

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

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.

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Cost of Products Revenue

	Three Months Ended July 31,
	2006			Change		2005
Cost of products revenue	$	478,000		(31	)%	$	695,000
Percent of products revenue	8		%			9		%

	Nine Months Ended July 31,
	2006			Change		2005
Cost of products revenue	$	1,559,000		(18	)%	$	1,902,000
Percent of products revenue	9		%			8		%

Cost of products revenue consists of manufacturing costs, royalties to third-party vendors, technology costs and overhead costs.  Cost of products revenue decreased by $217,000, or 31%, for the three months ended July 31, 2006 as compared to the three months ended July 31, 2005 and cost of products revenue decreased by $343,000, or 18%, for the nine months ended July 31, 2006 as compared to the nine months ended July 31, 2005.  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 October 31, 2006, 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 July 31, 2006 and that cost of products revenue as a percent of products revenue for the three months ending October 31, 2006 will be generally consistent with that incurred during the three months ended July 31, 2006.

Cost of SCOsource Licensing Revenue 

	Three Months Ended July 31,
	2006		Change		2005
Cost of SCOsource licensing revenue	$	2,315,000	(25	)%	$	3,085,000

	Nine Months Ended July 31,
	2006		Change		2005
Cost of SCOsource licensing revenue	$	10,087,000	7	%	$	9,467,000

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 $770,000, or 25%, during the three months ended July 31, 2006 as compared to the three months ended July 31, 2005.  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), offset by increases in legal services provided by technical, industry, damage and other experts in connection with the SCO Litigation.  Cost of SCOsource licensing revenue increased by $620,000, or 7%, during the nine months ended July 31, 2006 as compared to the nine months ended July 31, 2005.  This increase was primarily attributable to significant work performed by technical, damage and industry experts and other consultants in connection with the SCO Litigation during the nine months ended July 31, 2006, offset by a reduction in expenses associated with the quarterly payments made to the Law Firms

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as only two quarterly payments were made during the nine months ended July 31, 2006 as compared to three quarterly payments made during the nine months ended July 31, 2005.

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

Cost of Services Revenue

	Three Months Ended July 31,
	2006			Change		2005
Cost of services revenue	$	666,000		(5	)%	$	700,000
Percent of services revenue	56		%			51		%

	Nine Months Ended July 31,
	2006			Change		2005
Cost of services revenue	$	2,012,000		(8	)%	$	2,195,000
Percent of services revenue	52		%			52		%

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 $34,000, or 5%, for the three months ended July 31, 2006 compared to the three months ended July 31, 2005 and decreased by $183,000, or 8%, for the nine months ended July 31, 2006 as compared to the nine months ended July 31, 2005.  This decrease was primarily attributable to reduced numbers of employees and related costs.

For the three months ending October 31, 2006, 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 July 31, 2006 and that cost of services revenue as a percent of services revenue for the three months ending October 31, 2006 will be generally consistent with that incurred during the three months ended July 31, 2006.

Sales and Marketing

	Three Months Ended July 31,
	2006			Change		2005
Sales and marketing expenses	$	3,111,000		6	%	$	2,935,000
Percent of total revenue	42		%			31		%

	Nine Months Ended July 31,
	2006			Change		2005
Sales and marketing expenses	$	8,656,000		(2	)%	$	8,849,000
Percent of total revenue	40		%			32		%

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 increase in sales and marketing expenses of $176,000, or 6%, for the three months ended July 31, 2006 compared with the three months ended July 31, 2005 was

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primarily attributable to increased travel costs, increased marketing costs associated with the release of our mobile services product offerings and from stock-based compensation.  The decrease in sales and marketing expense of $193,000, or 2%, for the nine months ended July 31, 2006 compared with the nine months ended July 31, 2005 was primarily attributable to decreased spending on co-operative advertising and decreased discretionary spending, offset by increases in spending related to the release of our mobile services product offerings and from stock-based compensation.  Included in sales and marketing expenses for the three months ended July 31, 2006 and 2005 was $102,000 and $0, respectively, for stock-based compensation.  Included in sales and marketing expenses for the nine months ended July 31, 2006 and 2005 was $261,000 and $14,000, respectively, for stock-based compensation.

For the three months ending October 31, 2006, we anticipate that the dollar amount of sales and marketing expenses will be generally consistent with that incurred during the three months ended July 31, 2006.

Research and Development

	Three Months Ended July 31,
	2006			Change		2005
Research and development expenses	$	2,029,000		5	%	$	1,940,000
Percent of total revenue	27		%			21		%

	Nine Months Ended July 31,
	2006			Change		2005
Research and development expenses	$	5,786,000		(6	)%	$	6,145,000
Percent of total revenue	26		%			22		%

Research and development expenses consist of the salaries and benefits of software engineers, consulting expenses and corporate allocations.  Research and development expenses increased by $89,000, or 5%, for the three months ended July 31, 2006 compared with the three months ended July 31, 2005.  The increase in research and development expenses was primarily attributable to increased travel costs and from stock-based compensation.  Research and development expenses decreased by $359,000, or 6%, for the nine months ended July 31, 2006 compared with the nine months ended July 31, 2005, which was primarily attributable to decreased personnel and personnel-related costs, offset by an increase in stock-based compensation.  Included in research and development expenses for the three months ended July 31, 2006 and 2005 was $41,000 and $0, respectively, of stock-based compensation.  Included in research and development expenses for the nine months ended July 31, 2006 and 2005 was $97,000 and $8,000, respectively, of stock-based compensation.

For the three months ending October 31, 2006, we anticipate that the dollar amount of research and development expenses will be generally consistent with that incurred during the three months ended July 31, 2006.

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General and Administrative

	Three Months Ended July 31,
	2006			Change		2005
General and administrative expenses	$	1,829,000		11	%	$	1,647,000
Percent of total revenue	25		%			18		%

	Nine Months Ended July 31,
	2006			Change		2005
General and administrative expenses	$	5,139,000		(6	)%	$	5,446,000
Percent of total revenue	23		%			20		%

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

For the three months ending October 31, 2006, we anticipate that the dollar amount of general and administrative expenses will be lower than that incurred during the three months ended July 31, 2006.

Amortization of Intangibles

	Three Months Ended July 31,
	2006			Change		2005
Amortization of intangibles	$	593,000		0	%	$	593,000
Percent of total revenue	8		%			6		%

	Nine Months Ended July 31,
	2006			Change		2005
Amortization of intangibles	$	1,778,000		0	%	$	1,779,000
Percent of total revenue	8		%			6		%

Equity in Income (Loss) of Affiliate

We account for our ownership interests in companies in which we own at least 20 percent and less than 50 percent using the equity method of accounting.  Under the equity method, we record our portion of the entity’s net income or net loss in our consolidated statements of operations.

During the three months ended July 31, 2006 and 2005, we recorded $0 and $(19,000), respectively, that related to equity in income (loss) of SCO China, our 30%-owned Chinese

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company.  During the nine months ended July 31, 2006 and 2005, we recorded $(8,000) and $51,000, respectively, that related to equity in income (loss) of SCO China.

Other Income (Expense), net

Other income (expense) consisted of the following components for the three and nine months ended July 31, 2006 and 2005:

	Three Months Ended July 31,						Nine Months Ended July 31,
	2006			2005			2006		2005
Interest income	$	191,000		$	122,000		$	542,000	$	257,000
Other income (expense), net	(64,000		)	(149,000		)	46,000		1,025,000
Total	$	127,000		$	(27,000	)	$	588,000	$	1,282,000

Interest income increased by $69,000 and $285,000, respectively, from the three and nine months ended July 31, 2005 as compared to the three and nine months ended July 31, 2006 and was primarily attributable to higher interest rates earned on our cash and available-for-sale marketable securities balances as well as higher cash and available-for-sale marketable securities balances.   The higher cash balance is primarily attributable to our equity financing described in Note 6 to the Notes to Condensed Consolidated Financial Statements.

The increase in other income (expense), net, of $85,000 from the three months ended July 31, 2005 as compared to the three months ended July 31, 2006 was primarily attributable to a reduction in realized losses as a result of changes in foreign currency rates and balances.  The decrease in other income (expense), net, of $979,000 from the nine months ended July 31, 2005 as compared to the nine months ended July 31, 2006 was primarily attributable to (i) the collection of a $500,000 note receivable from Vintela, Inc., and (ii) proceeds of approximately $779,000 received from the sale of shares we held of Troll Tech AS, which both occurred during the nine months ended July 31, 2005.

Provision for Income Taxes

The provision for income taxes was $107,000 for the three months ended July 31, 2006 and $84,000 for the three months ended July 31, 2005 and was $308,000 for the nine months ended July 31, 2006 and $321,000 for the nine months ended July 31, 2005.  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 $4,272,000 as of October 31, 2005 to $8,861,000 as of July 31, 2006.  During this same time period, our investment in available-for-sale marketable securities decreased from $6,165,000 to $5,099,000.  Our working capital also increased from $8,669,000 as of October 31, 2005 to $9,871,000 as of July 31, 2006.  The increase in the combined cash and cash equivalents and available-for-sale marketable securities balance was primarily attributable to the issuance of approximately 2,852,000 shares of our common stock for net proceeds of approximately $9,809,000 in November 2005 offset by cash expenditures related to the SCO Litigation.

Total cash and cash equivalents and available-for-sale marketable securities was $13,960,000 as of July 31, 2006.  As of July 31, 2006, we also had $2,010,000 of restricted cash, of which $1,561,000 is set aside to cover expert and other costs related to our SCO Litigation and $449,000 is set aside for royalties payable to Novell.

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We intend to use the cash and cash equivalents and available-for-sale marketable securities as of July 31, 2006 to run our UNIX business and pursue the SCO Litigation.

Our net cash used in operating activities during the nine months ended July 31, 2006 was $7,050,000 and was attributable to a net loss of $12,855,000, non-cash items of $3,595,000 and changes in operating assets and liabilities of $2,210,000.

Our net cash used in operating activities during the nine months ended July 31, 2005 was $19,460,000.  Cash used in operating activities for the nine months ended July 31, 2005 was attributable to a net loss of $7,295,000, non-cash expenses of $2,304,000 and changes in operating assets and liabilities of $14,469,000.

Our investing activities have historically consisted of equipment purchases and the purchase and sale of available-for-sale marketable securities.  During the nine months ended July 31, 2006, cash provided by investing activities was $1,109,000, which was primarily a result of sales, net of purchases, of available-for-sale marketable securities of $1,066,000 and a dividend received from our 30% owned Chinese company of $308,000, offset by purchases of equipment of $265,000.

During the nine months ended July 31, 2005, cash provided by investing activities was $12,447,000, which was primarily a result of sales, net of purchases, of available-for-sale marketable securities, of $12,680,000, which was offset, in part, by purchases of equipment of $233,000.

Our financing activities provided $10,425,000 of cash during the nine months ended July 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 $9,809,000, the exercise of options to acquire common stock of $35,000 and proceeds of $613,000 received from the sale of common stock through our employee stock purchase program, 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 financing activities provided $955,000 of cash during the nine months ended July 31, 2005 and consisted primarily of proceeds received from the exercise of stock options of $235,000 and proceeds from the sale of shares of common stock to our employees through our employee stock purchase program of $720,000.

Our net accounts receivable balance decreased from $6,343,000 as of October 31, 2005 to $4,072,000 as of July 31, 2006, primarily as a result of lower invoicing and revenue generated during the three months ended July 31, 2006 as compared to the three months ended October 31, 2005.  The majority of our accounts receivable are current and our allowance for doubtful accounts was $97,000 as of July 31, 2006, 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 and nine months ended July 31, 2006 and 2005 were not significant.

On October 31, 2004, we entered into an engagement agreement (the “Engagement Agreement”) with the Law Firms.  The Engagement Agreement supercedes and replaces the original engagement agreement that was entered into in February 2003.  The Engagement Agreement governs the relationship between us and the Law Firms in connection with their representation of us in the SCO Litigation, through the end of our current litigation with IBM.  Our purpose in entering into this Engagement Agreement was to limit the cash expenditures needed to pursue the SCO Litigation.  The Engagement Agreement provides for the payment of approximately $26,000,000 for all attorneys’ fees in connection with the SCO Litigation through the end of our current litigation with IBM and the escrow of at least $5,000,000 for the payment of

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any expert, consulting and other expenses.  As of July 31, 2006, we had paid the entire $26,000,000.

On June 5, 2006, we entered into an amendment to the Engagement Agreement and agreed with the Law Firms to deposit an additional $5,000,000 into the escrow account to cover additional expert, consulting and other expenses.  In the event that we exhaust these funds, we will continue to pay for expert, consulting and other expenses through the conclusion of our litigation with IBM.  As of July 31, 2006, $1,561,000 remained in the escrow account and was classified as a component of restricted cash.

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 specifically 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 July 31, 2006:

	Total		Less than 1 year		1 – 3 years		3 -5 years		More than 5 years
Operating lease obligations	$	2,030,000	$	1,425,000	$	605,000	$	—	$	—

As of July 31, 2006, we did not have any long-term debt obligations, purchase obligations or material capital lease obligations.

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.  This 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, the SCO Litigation and strategic initiatives exceeds our current cash resources and cash generated from operations, 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

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Litigation.  We may also not be able to raise capital for any number of reasons including those listed under Part II, Item 1A – Risk Factors.  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 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 expectation that our sales channel should continue to provide reliable UNIX operating systems for small-to-medium sized business customers;

·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;

·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, 2006 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 October 31, 2006 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 July 31, 2006;

·Our expectation for the three months ending October 31, 2006 that the dollar amount of our cost of services revenue and that cost of services revenue as a percent of services revenue will be generally consistent to that incurred during the three months ended July 31, 2006;

·Our expectation for the three months ending October 31, 2006 that the dollar amount of our sales and marketing expenses will be generally consistent to that incurred during the three months ended July 31, 2006;

·Our expectation for the three months ending October 31, 2006 that the dollar amount of our research and development expenses will be generally consistent to that incurred during the three months ended July 31, 2006;

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·Our expectation for the three months ending October 31, 2006 that the dollar amount of our general and administrative expenses will be lower than that incurred during the three months ended July 31, 2006;

·Our intention to use cash and cash equivalents and available-for-sale 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;

·Our expectation for the three months ending October 31, 2006 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 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.  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.

Interest Rate Risk.  The primary objective of our cash management strategy is to invest available funds in a manner that assures maximum safety and liquidity and maximizes yield within such constraints.  We believe that a hypothetical movement in interest rates, either up or down, 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 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 percent and less than 50 percent using the equity method of accounting.  Under the equity method, we record our portion of the entity’s 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

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when events and circumstances indicate that these investments may be impaired.  As of July 31, 2006, our investments balance totaled approximately $291,000 and consisted solely of our investment in a 30% owned 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, 2005.  The following discussion is limited to certain recent developments concerning our legal proceedings and should be read in conjunction with our Annual Report on Form 10-K.   In addition, for more information regarding our legal proceedings, please see Note 4 included in Part 1, Item 1.  Unaudited Financial Statements – Notes to Condensed Consolidated Financial Statements, which information is incorporated herein by reference.

IBM Corporation

On February 13, 2006, IBM filed a motion with the court seeking to limit our claims.  IBM argues that of the 294 items identified by us in our December 22, 2005 filing, 201 did not meet the level of specificity required by the court.  IBM requested that we be limited to 93 items set forth in the December 22, 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 our technology disclosures from the case.  Although this ruling is a significant limitation of the number of technology disclosures we challenged in our December 22, 2005 filing, it also means that over 100 of our challenged items remain in the case.  On July 13, 2006, we filed objections to the Magistrate Judge’s order with the district court; those objections challenge the process and the result embodied in the Magistrate Judge’s order and we expect a hearing to be set in the near future.

On June 8, 2006, IBM filed a motion to confine our claims to, and strike allegations in excess of, the final disclosures.  In this motion, IBM claims that our technology expert reports go beyond the disclosures contained in our December 22, 2005 submission to the court and that those

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expert reports should be stricken to that extent.  No hearing has been set on that motion and no ruling has been made.  We believe that the motion lacks merit and have filed an opposition to the motion.

Both parties have filed expert reports and expert discovery is under way.

Novell, Inc.

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 we granted SuSE the right to use our intellectual property through our participation in the UnitedLinux initiative in 2002 and through its acquisition of SuSE, Novell acquired SuSE’s rights as a member of UnitedLinux.  On May 26, 2006, we filed a response to Novell’s motion to stay, and on June 27, 2006, we responded to Novell’s request for arbitration. On August 21, 2006, the court ordered that the claims relating to the SuSE arbitration should be stayed but the other claims in the case should proceed.

The three-person arbitration panel has been selected for the SuSE arbitration in Switzerland and that process will be commencing in the near future.  We do not yet know the schedule of the proceedings.

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.

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, 2005 and 2004, we incurred net losses applicable to common stockholders of $10,726,000 and $16,227,000, respectively, and for the nine months ended July 31, 2006 we incurred a net loss of $12,855,000.  As of July 31, 2006, our accumulated deficit was $247,797,000.

If our revenue from the sale of our UNIX products and services continues to decline, we will need to further reduce operating expenses to generate positive cash flow. 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.

We may not prevail in our SCO Litigation, 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.  In our action against IBM, we seek damages for claims generally relating to our allegation that IBM has inappropriately used and distributed our UNIX operating system  (including methods and concepts) and derivative works based on UNIX in connection with IBM’s efforts to promote the Linux operating system.  IBM has responded to our claims and brought counterclaims against us asserting generally that we do not have the right to assert claims based on our ownership of UNIX intellectual property against IBM or others in the Linux market.  Discovery is continuing in the case.  If we do not prevail in our action against IBM, or if IBM is successful in its counterclaims against us, our business and results of operations would be materially harmed and we may not be able to continue in business.  The litigation with IBM and others will be costly, and our costs for legal fees and related expenses

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have been and will continue to be substantial and may exceed our capital resources.  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.

As a result of the SCO Litigation, participants in the Linux marketplace and others affiliated with IBM or sympathetic to the Linux movement have taken actions attempting to negatively affect our business and our SCOsource efforts.  Linux proponents have taken a broad range of actions against us, including, for example, attempting to influence participants in the markets in which we sell our products to reduce or eliminate the amount of our products and services they purchase from us.  It is likely that similar efforts will continue.  There is a risk that additional participants in our marketplace will view the SCO Litigation in a negative light, and we may lose support from such participants.  Any of the foregoing could adversely affect our position in the marketplace, our results of operations, our stock price and our ability to stay in business.

As a response to our claim that our UNIX operating system and derivative works based on UNIX have inappropriately been included in Linux, Novell has publicly asserted its belief that it owns certain rights in UNIX, and Novell filed 15 copyright applications with the United States Copyright Office related to UNIX.  Novell has claimed to have retained rights related to UNIX source code licenses, including the license with IBM.  Novell asserts it has the right to take action on behalf of SCO in connection with such licenses, including termination rights.  Novell has purported to veto our termination of the IBM, Sequent and SGI licenses.  We have asserted that we obtained the UNIX business, source code, claims and copyrights when we acquired the assets and operations of the server and professional services groups from The Santa Cruz Operation in May 2001, which had previously acquired all such assets and rights from Novell in 1995 pursuant to an asset purchase agreement, as amended.  In January 2004, in response to Novell’s actions, we brought suit against Novell for slander of title seeking relief for Novell’s alleged bad faith effort to interfere with our rights related to UNIX, UNIX derivative works and our UnixWare products.  Novell twice unsuccessfully sought to have the case dismissed.

On July 29, 2005, Novell filed its Answer and Counterclaims against us, asserting counterclaims for our alleged breaches of the Asset Purchase Agreement between Novell and our predecessor-in-interest, The Santa Cruz Operation, Inc., 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, we filed a motion for leave to amend our complaint to assert additional claims against Novell, including copyright infringement, unfair competition and a breach of Novell’s limited license to use our UNIX source code.  Novell did not oppose our motion so our Second Amended Complaint has been filed.  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 we granted SuSE the right to use our intellectual property through our participation in the UnitedLinux initiative in 2002 and through its acquisition of SuSE, Novell acquired SuSE’s rights as a member of UnitedLinux.  On May 26, 2006, we filed a response to Novell’s motion to stay, and on June 27, 2006, we responded to Novell’s request for arbitration. On August 21, 2006, the court ordered that the claims relating to the SuSE arbitration should be stayed but the other claims in the case should proceed.

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Notwithstanding our assertions of full ownership of critical UNIX-related intellectual property rights, as set forth above, including copyrights, and even if we are successful in our legal action against Novell and end users such as AutoZone and DaimlerChrysler, the efforts of Novell and the other Linux proponents described above may cause further damage to our business including our ability to monetize our UNIX assets.  These efforts of Linux proponents also may increase the negative view some participants in our marketplace have regarding our SCO Litigation and may contribute to creating confusion in the marketplace about the validity of our claim that the unauthorized misappropriation of our UNIX product and derivative works based on UNIX into Linux violates our contracts and copyrights.  Increased negative perception and potential confusion about our claims in our marketplace could impede our continued pursuit of the SCO Litigation and negatively impact our business.  For example, we believe that the decline in SCOsource revenue has been, in part, attributable to Novell’s claim of UNIX copyright ownership, which may have caused potential customers to delay or forego licensing until an outcome in this legal matter has been reached.

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, Hewlett Packard, Sun, Microsoft and other 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 enhance our products to meet these evolving needs, we may not remain competitive and be able to sustain or grow 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 and changing customer requirements.  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.

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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 and our 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 and would adversely impact our results of operations and liquidity.

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 on 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.

In addition, regulators or others in the Linux market and some foreign regulators have initiated or in the future may initiate legal actions against us, all of which may negatively impact our operations and future operating performance.

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

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Our future SCOsource licensing revenue is uncertain.

We initiated the SCOsource licensing effort in the year ended October 31, 2003 to review the status of UNIX licensing and sublicensing agreements.  This effort resulted in the execution of two significant vendor license agreements and generated $25,846,000 in revenue during the year ended October 31, 2003.  During the years ended October 31, 2004, and 2005, our SCOsource licensing revenue declined to only $829,000, and $166,000, respectively, and during the nine months ended July 31, 2006, our SCOsource licensing revenue was $95,000.  Because of the uncertainties related to SCOsource licensing revenue, we are unable to estimate the amount and timing of future SCOsource licensing revenue, if any.  If we do receive revenue from this source, it may be sporadic and fluctuate from quarter to quarter.  Additionally, the success of these initiatives may depend on the strength of our intellectual property rights and contractual claims regarding UNIX, including the strength of our claim that unauthorized UNIX source code and derivative works are prevalent in Linux.

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.

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 significant fluctuations in our SCOsource licensing revenue 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:

·ability to successfully negotiate and complete licensing and other agreements related to our intellectual property;

·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 activities of short sellers;

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

·results of, developments in, or costs of our SCO Litigation;

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

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

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

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.

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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 foreign operations, including development facilities, sales personnel and customer support operations in Europe, 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 harm 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 percent 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.  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.

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

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consulting and other costs as agreed to in the Engagement Agreement with our legal counsel in the SCO Litigation.

We have issued options under our equity compensation plans without complying with registration or qualification requirements under the securities laws of California, Georgia and possibly other states, and, as a result, we may incur rescission liability for such options and may face additional potential claims under state securities laws.

In addition to the shares issued under the ESPP, we have granted options under our 1999 Omnibus Stock Incentive Plan and 2002 Omnibus Stock Incentive Plan without complying with the registration or qualification requirements under the securities laws of California, Georgia and possibly other states.  We may face rescission liability to plan participants holding unexercised stock options in these states.  Additionally, regulatory authorities may require us to pay fines or they may impose other sanctions upon us, and we may face other claims by plan participants other than rescission claims.

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 our intellectual property claims 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 August 31, 2006, we have issued outstanding options to purchase up to approximately 4,843,000 shares of common stock with an average exercise price of $4.11 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 4.4% 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 13.5% 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.

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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.

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

3.1Amended 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)).

3.2Certificate 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)).

3.3Certificate 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)).

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

3.5Certificate 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)).

3.6Certificate 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)).

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10.1First Amendment to the Letter Agreement dated October 31, 2004 among The SCO Group, Inc., Boies, Schiller & Flexner LLP, Kevin McBride, and Berger Singerman (incorporated by reference to Exhibit 99.1 to SCO’s Current Report on Form 8-K filed on June 8, 2006).

31.1Certification 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.

31.2Certification 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.

32.1Certification 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.

32.2Certification 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: September 13, 2006		THE SCO GROUP, INC.
	By:	/s/      Bert B. Young
		Bert B. Young
		Duly Authorized Officer and
		Chief Financial Officer
		(Principal Financial and
		Accounting Officer)

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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)).
10.1	First Amendment to the Letter Agreement dated October 31, 2004 among The SCO Group, Inc., Boies, Schiller & Flexner LLP, Kevin McBride, and Berger Singerman (incorporated by reference to Exhibit 99.1 to SCO’s Current Report on Form 8-K filed on June 8, 2006).
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.

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