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| SCOX > SEC Filings for SCOX > Form 10-K on 28-Jan-2004 | All Recent SEC Filings |
28-Jan-2004
Annual Report
This Management's Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Form 10-K 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 discussed in the subsection entitled "Forward Looking Statements and Factors That May Affect Future Results and Financial Condition" and the subsection entitled "Risk Factors" below under Part II, Item 7A of this Form 10-K. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto included in Part II, Item 8 of this Form 10-K. All information presented herein is based on our fiscal year ended October 31, 2003. 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. to acquire substantially all of the assets and operations of
the server and professional services groups of The Santa Cruz Operation, (now
known as Tarantella, Inc.). In connection with this acquisition, Caldera Systems
became a wholly-owned subsidiary of Caldera International, Inc. 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, Inc. Our operating results for fiscal year 2001 include the results of Caldera Systems for the period of November 1 through May 6 and include the results of Caldera International (which included the acquired operations of the server and professional services groups from The Santa Cruz Operation) from May 7 through October 31. On May 16, 2003, our stockholders approved our corporate name change to The SCO Group, Inc.
Recent Developments. During fiscal year 2003, we launched our SCOsource intellectual property initiatives and brought a lawsuit against IBM. We disclose our lawsuit against IBM and its current status in more detail above under Part 1, Item 3 of this Form 10-K. On January 20, 2004, we brought suit against Novell, Inc. for slander of title seeking relief for Novell's alleged bad faith effort to interfere with our copyrights related to our UNIX source code and derivative works and our UnixWare products. We disclose our lawsuit against Novell in more detail above under Part I, Item 3 of this Form 10-K.During fiscal year 2003, we increased our cash balance as a combined result of improved operations in our core UNIX business and license fees generated from our SCOsource initiatives. To further strengthen our competitive position, allow for investment in our UNIX business and pursue our intellectual property protection strategy, we issued 50,000 shares of our Series A Convertible Preferred Stock and raised net proceeds of $47,740,000. We believe that our cash and equivalents balance as of October 31, 2003 of $64,428,000 will be adequate for us to execute our current UNIX business strategy as well as to continue to pursue our intellectual property claims. Our operating strategy for fiscal year 2004 includes strengthening our core UNIX business by investing in our UNIX technology as well as pursuing our SCOsource licensing initiatives to protect our rights in the UNIX source code and our other intellectual property.
Business Focus
We generate revenue primarily from two sources: product and services revenue from our UNIX operating systems business and license fees from our SCOsource licensing business.
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 our worldwide, indirect, leveraged channel of partners, which includes distributors and independent solution providers. We have local offices in a number of countries that provide support and services to customers and resellers in that geographic area. The other principal channel for selling and marketing our UNIX products is through major corporations that have a large number of replicated sites or franchisees. We access these corporations through their information technology or purchasing departments with our Area Sales Managers 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 OEMs through our direct sales team in the United States and our reseller channel in countries outside the United States. Until fiscal year 2003, the majority of our revenue and our operating expenses were derived from our UNIX business.The revenue derived from our UNIX business was $53,408,000, $64,241,000 and $40,441,000 for fiscal years ended 2003, 2002 and 2001. The revenue from this business has been declining in each of the last four years primarily as a result of increased competition from alternative operating systems, particularly Linux, lower information technology spending and the general economic slowdown. In our results of operations, we recognize revenue from agreements for support and maintenance contracts and other long-term contracts that have been previously invoiced and are included in deferred revenue. Our deferred revenue balance has declined from $10,056,000 as of October 31, 2002 to $5,501,000 as of October 31, 2003, and this decline in deferred revenue may continue into future quarters, which may
have a negative impact on our operating system platform products revenue. Our future operating system platform revenue may be adversely impacted and may continue to decline if we are unable to replenish these deferred revenue balances with long-term maintenance and support contracts or replace them with other sustainable revenue streams. If we are unable to continue to generate positive cash flow and profitable operations, our operations may be adversely impacted.
The decline in our UNIX business revenue may be accelerated if industry partners withdraw their support as a result of our SCOsource initiatives and in particular any lawsuits against end users violating our intellectual property and contractual rights. Our SCOsource initiatives, particularly lawsuits against such end users, 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.
In an effort to offset this decrease in UNIX revenue, we have significantly decreased our operating costs and increased our gross margin over the last three fiscal years. Operating costs have decreased from $159,154,000 in fiscal year 2001 to $70,101,000 in fiscal year 2002 to $55,896,000 in fiscal year 2003. We have reduced the number of employees and eliminated redundant facilities while still preserving our worldwide infrastructure. Our gross margin percentage from our UNIX business has increased from 63 percent in fiscal year 2001, to 71 percent in fiscal year 2002 to 80 percent in fiscal year 2003. We have accomplished this by reducing excess manufacturing and overhead costs, reducing our third-party royalty and technology costs and decreasing the number of employees in our services organization.
An important initiative for our UNIX business for the 2004 fiscal year will be to maintain the level of investment in and commitment to our UNIX operating systems. As part of this initiative, we intend to increase our research and development costs for fiscal year 2004 and provide our OpenServer and UnixWare products with increased system reliability, maintain backward compatibility with existing applications and software, provide increased application support, provide additional hardware support, integrate widely-used internet applications and increase system performance. These enhancements will not have a direct impact on our short-term UNIX revenue because of the long adoption cycle for new operating system purchases and our long operating system product sales cycle.
SCOsource Business. Over the last fiscal year, we became aware that our UNIX code and derivative works had been inappropriately included in the Linux operating system. We believe the inclusion of our UNIX code and derivative works in Linux has been a major contributor to the decline in our UNIX business because users of Linux generally do not pay for the operating system, only minimal fees, if any, for service and maintenance. The Linux operating system competes directly with our OpenServer and UnixWare products and has taken significant market share from these products.To offset the decline in our UNIX business and review the status of our UNIX licensing and sublicensing agreements, we initiated our SCOsource licensing initiatives in January 2003. This effort resulted in the execution of two significant license agreements during fiscal year 2003 and generated $25,846,000 in SCOsource business revenue.
Our future success with our SCOsource initiatives and future revenue from SCOsource licenses will depend on our ability to protect our UNIX intellectual property. We will continue to devote resources to our SCOsource initiatives, and we expect legal fees and other SCOsource related costs will substantially increase in fiscal year 2004. In addition to pursuing large vendor licensing contracts similar to those executed in fiscal year 2003, we are implementing an IP licensing campaign to Linux end users. This IP licensing effort will allow Linux end users to continue to use our UNIX source code and derivative works found in Linux. We have announced worldwide availability of the IP license and plan to significantly increase our SCOsource sales team in fiscal 2004 to implement these licensing strategies.
Because of the uncertainties related to SCOsource licensing revenue, we are unable to estimate the amount and timing of future SCOsource licensing revenue. This uncertainty represents a significant risk and challenge for us, both in the short and long term. If we do receive revenue from this source, it may be sporadic and fluctuate from quarter to quarter. Our SCOsource initiatives are unlikely to produce a stable or predictable revenue stream for the foreseeable future. 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. We do not expect significant SCOsource revenue in the first quarter of fiscal year 2004, but anticipate that revenue from vendor licenses and IP licenses will increase throughout fiscal year 2004.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with generally accepted accounting principles in the United States and our discussion and analysis of our financial condition and results of operations requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Note 1 of the notes to consolidated financial statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in preparation of our consolidated financial statements. We base our estimates on historical experience, current trends, future projections and on various other assumptions we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates. We believe the following to be our critical accounting policies because they are both important to the portrayal of our financial condition and results and they require us to make judgments and estimates about matters that are inherently uncertain.
Our critical accounting policies and estimates include the following:
Ί Ί Revenue recognition;
Ί Ί Deferred income taxes and related valuation allowances;
Ί Ί Fair value of derivative financial instrument;
Ί Ί Impairment of long-lived assets; and
Ί Ί Allowances for doubtful accounts.
Revenue Recognition. We recognize revenue in accordance with
Statement of Accounting Position ("SOP") 97-2, as amended, and Staff Accounting
Bulletin ("SAB") 104. Revenue recognition in accordance with these
pronouncements can be complex due to the nature and variability of our sales
transactions. We recognize products revenue and SCOsource revenue upon shipment
if a signed contract exists, the fee is fixed and determinable, collection of
the resulting receivable is probable and product returns are reasonably
estimable, except for sales to distributors, which are recognized upon sale by
the distributor to resellers or end users. We recognize product revenue from
royalty payments upon receipt of quarterly royalty reports from OEMs related to
their product sales.
The majority of our revenue transactions relate to product sales only.
On occasion we have revenue transactions that include multiple elements (i.e.,
delivered and undelivered elements including maintenance, support and other
services). For invoices or contracts involving multiple elements we allocate
revenue to each component of the contract based on objective evidence of its
fair value. The fair value of each element is based on amounts charged when such
elements are sold in separate transactions. We recognize revenue allocated to
undelivered products when the criteria for revenue recognition set forth above
have been met.
Estimates used in our revenue recognition include the determination of credit-worthiness and verification of sales-out reporting to end users through our two-tier distribution channel. To the extent these estimates were inaccurate; our recognized revenue would be adversely impacted and would harm our results of operations. Additionally, if our business conditions change or our revenue contracts begin to contain more multiple elements, our future revenue recognition in future periods may be impacted as a larger component of revenue may be deferred. As of October 31, 2003, our deferred revenue balance was $5,501,000 and related primarily to product maintenance and support contracts.
Deferred Income Taxes 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 and other future events, the effects of which cannot be determined. We have provided a valuation allowance of $52,908,000 and $50,317,000 against our entire net deferred tax asset as of October 31, 2003 and 2002. The valuation allowance was recorded because of our history of net operating losses and the uncertainties regarding our future operating profitability and taxable income.
Fair Value of Derivative Financial Instrument. On October 16, 2003,
we issued 50,000 shares of our Series A Convertible Preferred Stock for $1,000
per share. The net proceeds from the sale of the preferred stock were
$47,740,000. The terms of the preferred stock include conversion and a number of
redemption provisions that represent a derivative financial instrument under
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as
amended. We determined that the conversion feature allowing the holders of the
preferred stock to acquire common shares is an embedded derivative financial
instrument that does not qualify as a scope exemption under the provisions of
Emerging Issues Task Force ("EITF") 00-19, "Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in a Company's Own Stock."
As of October 16, 2003, through the assistance of an independent
valuation firm, we determined the initial fair value of the derivative was
$18,069,000 and the value of the preferred stock was $29,671,000. We were
required to account for the conversion feature as an embedded derivative since
the preferred stock instrument did not entitle the holders to equity features
such as voting rights and board representation. Significant estimates used by
management in the valuation of the preferred stock included an expected term of
three years, a yield rate for the security of 15 percent and the value of our
common stock of $19.89 on the date the preferred stock transaction closed. As of
October 31, 2003, the fair value of the derivative was $15,224,000 and the
decrease in fair value of $2,845,000 was recorded as other income in our
consolidated statement of operations for fiscal year 2003.
To account for the derivative, we will mark-to-market its value at each balance sheet date and will include in our consolidated statement of operations any changes in value as a component of other income or expense. Changes in the value of the derivative may be significant, as the value of our common stock at each balance sheet date will have a significant impact on the value of the derivative. For example, an increase in the value of our common stock by $1.00 may require us to record an expense of approximately $1,000,000, and, conversely, a decrease in our common stock by $1.00 may require us to record income of approximately $1,000,000. Additionally, had different estimates been used in the valuation of the derivative, the valuation results could have been materially different than reported, which would have impacted our results of operations.
Impairment of Long-lived Assets. We review our long-lived assets for impairment when events or changes in circumstances indicate that the book 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.
We performed an impairment analysis, utilizing a valuation of our goodwill as of October 31, 2003 in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," and determined that the goodwill reported in the accompanying consolidated balance sheets is not impaired.
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 business continue to decline or the value of our common stock were to significantly decrease, we may be required to record an impairment charge in a future period related to their carrying value of our long-lived assets.
Allowance for Doubtful Accounts. 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 have applied these policies consistently throughout fiscal years 2003, 2002 and 2001. Our allowance for bad debts based on our historical experience and specific review as of October 31, 2003, was $230,000. 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 acquisition of substantially all of the assets and operations of the server and professional services groups of The Santa Cruz Operation, which was completed in May 2001, significantly increased our revenue and operating expenses. Results for fiscal year 2001 are not directly comparable to fiscal years 2003 and 2002 because the operating results of the server and professional services groups acquired from The Santa Cruz Operation are only included in our consolidated statement of operations for the last two quarters of fiscal year 2001.
The following table presents our results of operations for the fiscal years ended October 31, 2003, 2002 and 2001:
Years Ended October 31,
---------------------------------
2003 2002 2001
-------- --------- ----------
(In thousands)
Statement of Operations Data:
Revenue:
Products $ 45,028 $ 52,975 $ 33,878
SCOsource licensing 25,846
Services 8,380 11,266 6,563
-------- --------- ----------
Total revenue 79,254 64,241 40,441
-------- --------- ----------
Cost of revenue:
Products 4,405 7,558 6,966
SCOsource licensing 9,163
Services 6,354 10,758 7,957
-------- --------- ----------
Total cost of revenue 19,922 18,316 14,923
-------- --------- ----------
Gross margin 59,332 45,925 25,518
-------- --------- ----------
Operating expenses:
Sales and marketing 24,392 29,554 33,858
Research and development 11,012 17,558 16,761
General and administrative 6,230 9,307 9,257
Restructuring charges 498 6,728 3,130
Amortization of goodwill and intangibles 3,190 2,853 10,664
Loss on disposition and impairment of 164 1,796 73,700
long-lives assets
Write-off of investments 250 1,180 8,309
Stock-based compensation 1,204 1,125 1,373
Compensation to law firms 8,956
In-process research and development 1,500
Cost-sharing arrangement with The Santa Cruz 602
Operation
-------- --------- ----------
Total operating expenses 55,896 70,101 159,154
-------- --------- ----------
Income (loss) from operations 3,436 (24,176 ) (133,636 )
-------- --------- ----------
Equity in losses of affiliates (62 ) (50 ) (648 )
Other income (expense), net 2,827 (168 ) 3,505
Provision for income taxes (774 ) (483 ) (578 )
-------- --------- ----------
Net income (loss) $ 5,427 $ (24,877 ) $ (131,357 )
-------- --------- ----------
Fiscal Years Ended October 31, 2003, 2002 and 2001
Revenue
2003 Change 2002 Change 2001
------------ ------ ------------ ------ ------------
Revenue $ 79,254,000 23 % $ 64,241,000 59 % $ 40,441,000
Revenue for fiscal year 2003 increased by $15,013,000, or 23 percent, from fiscal year 2002 and this increase was primarily attributable to license fees generated from our SCOsource licensing initiatives offset by decreases in UNIX products and services revenue. Revenue for fiscal year 2002 increased by $23,800,000, or 59 percent, over fiscal year 2001 and this increase was primarily attributable to a full
year of acquired operations from the server and professional services groups acquired from The Santa Cruz Operation.
Revenue generated from our UNIX operating divisions (Americas and International) and SCOsource division was as follows:
2003 Change 2002 Change 2001
------------ ------ ------------ ------ ------------
Americas revenue $ 29,175,000 (12 %) $ 32,973,000 56 % $ 21,103,000
Percent of total revenue 37 % 51 % 52 %
International revenue 24,124,000 (23 %) 31,268,000 62 % 19,338,000
Percent of total revenue 30 % 49 % 48 %
SCOsource revenue 25,846,000 n/a n/a
Percent of total revenue 33 %
Other revenue 109,000 n/a n/a
Percent of total revenue 0 %
The decrease in revenue from our International division for the 2003 fiscal year compared to prior periods was primarily related to the negative impact of the slowing European economy as well as from increased competition from other operating system products, particularly Linux, in Europe and Asia. We anticipate for fiscal year 2004 that UNIX revenue generated in the Americas and the International divisions will be lower than revenue generated in fiscal year 2003 and that the percentage split between these two UNIX divisions will be generally consistent with that in fiscal year 2003. Our UNIX product and services revenue may be lower than currently anticipated 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. This may occur as a result of our SCOsource initiatives and in particular as a result of any lawsuits we may bring against end users violating our intellectual property and contractual rights.
Products Revenue
2003 Change 2002 Change 2001
------------ ------ ------------ ------ ------------
Products revenue $ 45,028,000 (15 %) $ 52,975,000 56 % $ 33,878,000
Percent of total revenue 57 % 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. We rely heavily on our two-tier distribution channel for approximately 50 percent of our products revenue in the Americas and approximately 90 percent of our revenue in our International division, and any disruption in our distribution channel could have an adverse impact on future revenue.
The decrease in products revenue in fiscal year 2003 as compared with fiscal year 2002 was attributable to decreased sales of OpenServer and UnixWare products primarily resulting from increased competition in the operating system market, particularly Linux, and from a decrease in information technology spending and the worldwide economic slowdown. This impact was felt in all of our distribution channels and we believe that this competition from Linux will continue in future periods. The increase in product revenue in fiscal year 2002 over fiscal year 2001 was primarily attributable to revenue from a full year's sales of OpenServer and UnixWare products acquired as part of the acquisition of the server and professional services groups from The Santa Cruz Operation. We recognized OpenServer and UnixWare revenue only in the final two quarters of fiscal year 2001.
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:
2003 Change 2002 Change 2001
------------ ------ ------------ ------ ------------
OpenServer revenue $ 22,162,000 (24 %) $ 29,108,000 77 % $ 16,464,000
Percent of products revenue 49 % 55 % 49 %
UnixWare revenue 14,083,000 (0 %) 14,154,000 58 % 8,970,000
Percent of products revenue 31 % 27 % 26 %
Other products revenue 8,783,000 (10 %) 9,713,000 15 % 8,444,000
Percent of products revenue 20 % 18 % 25 %
SCOsource Licensing Revenue
2003 Change 2002 Change 2001
------------ ------ ----- ------ -----
SCOsource licensing revenue $ 25,846,000 n/a $ n/a $
Percent of total revenue 33 %
SCOsource licensing revenue was $25,846,000 for fiscal year 2003 as compared to no revenue from this source for fiscal years 2002 and 2001. This revenue is the result of our SCOsource initiatives, including our intellectual property licensing program, launched in January 2003. We initiated SCOsource for the purpose of protecting our intellectual property rights in our UNIX source code and derivative works. The SCOsource licensing revenue in fiscal year 2003 represents fees associated with vendor licenses entered into during the fiscal year from Sun and Microsoft. In fiscal year 2004, we anticipate continued revenue from our SCOsource activities in the form of vendor licenses and IP licenses, and that this revenue will be minimal in our first quarter of fiscal year 2004 and increase in future quarters. However, we are unable to predict the amount and timing of revenue from our SCOsource initiatives for future periods because of our lack of historical experience with this revenue source.
Services Revenue
2003 Change 2002 Change 2001
----------- ------ ------------ ------ -----------
Services revenue $ 8,380,000 (26 %) $ 11,266,000 72 % $ 6,563,000
Percent of total revenue 11 % 18 % 16 %
Services revenue consists primarily of annual and incident support fees, engineering services fees, professional services and education fees. These fees are typically charged and invoiced separately from UNIX products sales. The decrease in services revenue in fiscal year 2002, compared to fiscal year 2003 of $2,886,000 was in part due to a decrease in professional services resulting from a decrease in the demand for our custom enterprise-level projects as well as from a decrease in our support services, engineering services and team services agreements. The increase in services revenue in fiscal year 2002 over fiscal year 2001 was primarily attributable to a full year of revenue in fiscal year 2002 generated by the support and professional services groups acquired from The Santa Cruz Operation which generated services revenue for us only in the final two quarters of fiscal year 2001.
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 the renewal of certain annual support and services agreements from existing UNIX customers.
Cost of Products Revenue
2003 Change 2002 Change 2001
----------- ------ ----------- ------ -----------
Cost of products revenue $ 4,405,000 (42 %) $ 7,558,000 8 % $ 6,966,000
Percentage of products revenue 10 % 14 % 21 %
Cost of products revenue includes primarily overhead costs, manufacturing costs, royalties to third-party vendors and technology costs. Cost of products revenue decreased by $3,153,000 in fiscal year 2003 compared to fiscal year 2002. This decrease was primarily attributable to reduced overhead and manufacturing costs resulting from our cost reduction efforts, decreased royalties to third party vendors and lower amortized technology costs. Cost of products revenue increased by $592,000 in fiscal year 2002 compared to fiscal year 2001 primarily because of a full year of costs in fiscal year 2002 resulting from the acquired operations from The Santa Cruz Operation. These costs for the full year were partially offset by our initial undertaking to eliminate duplicate costs in manufacturing overhead.
For fiscal year 2004, we expect our cost of products revenue to be slightly less than in fiscal year 2003.
Cost of SCOsource Licensing Revenue
2003 Change 2002 Change 2001
----------- ------ ----- ------ -----
Cost of SCOsource licensing revenue $ 9,163,000 n/a $ n/a $
Percentage of SCOsource licensing revenue 35 %
Cost of SCOsource licensing revenue includes the salaries and related personnel costs of employees dedicated to the SCOsource licensing initiatives, legal and professional fees incurred in connection with our SCOsource initiatives, and an allocation of corporate costs.
Cost of SCOsource licensing revenue will fluctuate from quarter to quarter due in part to the unpredictability of the related SCOsource revenue and the level of legal and professional expenses incurred in connection with our efforts to protect our intellectual property rights. Legal expenses may include contingency payments made to the law firms engaged by us to protect our intellectual property rights. For fiscal year 2004, we will substantially increase the level of internal resources dedicated to our SCOsource initiatives as well as substantially increase the level of our legal expenses, however, we are unable to predict the percentage of cost of SCOsource licensing revenue for future quarters due to the unpredictability of the related licensing revenue.
Cost of Services Revenue
2003 Change 2002 Change 2001
----------- ------ ------------ ------ -----------
Cost of services revenue $ 6,354,000 (41 %) $ 10,758,000 35 % $ 7,957,000
Percentage of services 76 % 95 % 121 %
revenue
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 $4,404,000 for fiscal year 2003 compared to fiscal year 2002. This decrease was attributable to reduced employee and related costs in our support services and professional services groups as well as the elimination of certain third party support contracts in order to increase the gross margin for these groups. Cost of services revenue increased by $2,801,000 for fiscal year 2002 compared to fiscal year 2001. This increase was primarily attributable to a full year of costs in fiscal year 2002 resulting from the acquired operations from The Santa Cruz Operation.
For fiscal year 2004, we expect our cost of services revenue to be slightly less than in fiscal year 2003.
Sales and Marketing
2003 Change 2002 Change 2001
------------ ------ ------------ ------ ------------
Sales and marketing expense $ 24,392,000 (17 %) $ 29,554,000 (13 %) $ 33,858,000
Percentage of total revenue 31 % 46 % 84 %
Sales and marketing expenses consist of the salaries, commissions and other personnel costs of employees involved in the revenue generation process, as well as advertising and corporate allocations. The decrease in sales and marketing expenses from fiscal year 2002 to fiscal year 2003 of $5,162,000 and from fiscal year 2001 to fiscal year 2002 of $4,304,000 was primarily attributable to reductions in sales and marketing employees, reduced travel expenses, and less commissions and lower co-operative advertising costs as a result of lower revenue. Our sales and marketing personnel decreased from 176 as of October 31, 2001, to 133 as of October 31, 2002, to 114 as of October 31, 2003.
For fiscal year 2004, we anticipate that sales and marketing expenses will remain substantially consistent with 2003.
Research and Development
2003 Change 2002 Change 2001
------------ ------ ------------ ------ ------------
Research and development $ 11,012,000 (37 %) $ 17,558,000 5 % $ 16,761,000
expense
Percentage of total revenue 14 % 27 % 41 %
Research and development expenses consist of the salaries and benefits of software engineers, consulting expenses and corporate allocations. The decrease in research and development expense in fiscal year 2003 of $6,546,000 compared to fiscal year 2002 was primarily attributable to work force reductions. The increase in research and development expense in fiscal year 2002 of $797,000 over fiscal year 2001 was attributable to development work on our UNIX operating systems acquired during fiscal year 2001. Our research and development personnel decreased from 136 as of October 31, 2001, to 75 for fiscal year-ends October 31, 2002 and 2003.
For fiscal year 2004, we anticipate that research and development expenses will increase from fiscal year 2003 due to our recently initiated efforts to maintain and enhance our UNIX products.
General and Administrative
2003 Change 2002 Change 2001
----------- ------ ----------- ------ -----------
General and administrative $ 6,230,000 (33 %) $ 9,307,000 1 % $ 9,257,000
expense
Percentage of total revenue 8 % 14 % 23 %
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. The decrease in general and administrative expense from fiscal year 2002 to fiscal year 2003 of $3,077,000 was primarily attributable to staff centralization and reduction programs as well as decreases in external professional services. The increase from fiscal year 2001 to fiscal year 2002 of $50,000 was primarily attributable to support required for our worldwide operations acquired from The Santa Cruz Operation for the entire fiscal year following the acquisition. Our general and administrative personnel decreased from 103 as of October 31, 2001, to 61 as of October 31, 2002, to 55 as of October 31, 2003.
For fiscal year 2004, we anticipate that general and administrative expenses will increase in comparison with fiscal year 2003 due to the new compliance and reporting regulations under the Sarbanes-Oxley Act and other new regulatory requirements, increased legal costs as a result of lawsuits against end users violating our intellectual property and contractual rights and other litigation costs not categorized as SCOsource cost of revenue.
Restructuring Charges
2003 Change 2002 Change 2001
--------- ------ ----------- ------ -----------
Restructuring charges $ 498,000 (93 %) $ 6,728,000 115 % $ 3,130,000
Percentage of total revenue 1 % 10 % 8 %
During fiscal years 2003, 2002 and 2001, we recorded restructuring charges totaling $498,000, $6,728,000 and $3,130,000, respectively. The restructuring charges for fiscal years 2003, 2002 and 2001 were comprised of termination payments made to employees in connection with reductions in headcount, closure of certain facilities and adjustments to previously recorded amounts as actual payments made were less than recorded accruals. The decrease in fiscal year 2003 from fiscal years 2002 and 2001 was primarily attributable to fewer terminated employees and fewer vacated facilities.
The detail of the restructuring charges for fiscal years 2003, 2002 and 2001, are as follows (in thousands):
Balance
Balance at at
November 1, October
Fiscal 2001 2000 Additions Adjustments Utilization 31, 2001
----------------------- ------------- ----------- ------------- ------------- ---------
Severance and related $ $ 2,346 $ $ (1,654 ) $ 692
Facilities 784 1,507 * (239 ) 2,052
------------- ----------- ------------- ------------- ---------
Total $ $ 3,130 $ 1,507 $ (1,893 ) $ 2,744
------------- ----------- ------------- ------------- ---------
*The facilities adjustment of $1,507,000 was recorded in connection with the Company's acquisition of The Santa Cruz Operation.
Balance at Balance at
November 1, October
Fiscal 2002 2001 Additions Adjustments Utilization 31, 2002
------------------------- ----------- ----------- ------------- ------------- ----------
Severance and related $ 692 $ 4,053 $ $ (4,185 ) $ 560
Facilities 2,052 4,236 (1,561 )* (2,610 ) 2,117
----------- ----------- ------------- ------------- ----------
Total $ 2,744 $ 8,289 $ (1,561 ) $ (6,795 ) $ 2,677
----------- ----------- ------------- ------------- ----------
*The facilities adjustment of $1,561,000 was the result of successfully re-negotiating an existing lease commitment.
Balance at Balance at
November 1, October
Fiscal 2003 2002 Additions Adjustments Utilization 31, 2003
------------------------- ----------- ----------- ------------- ------------- ----------
Severance and related $ 560 $ 1,586 $ (273 ) $ (1,873 ) $
Facilities 2,117 (815 )* (954 ) 348
----------- ----------- ------------- ------------- ----------
Total $ 2,677 $ 1,586 $ (1,088 ) $ (2,827 ) $ 348
----------- ----------- ------------- ------------- ----------
* The facilities adjustment of $815,000 was the result of successfully negotiating out of lease commitments in connection with Company's winding down of the SCO Group, Ltd.
Amounts to be paid for restructurings are recorded as accrued liabilities.
Amortization of Goodwill and Intangibles
2003 Change 2002 Change 2001
----------- ------ ----------- ------ ------------
Amortization of goodwill and $ 3,190,000 12 % $ 2,853,000 (73 %) $ 10,664,000
intangibles
Percentage of total revenue 4 % 4 % 26 %
During fiscal years 2003, 2002 and 2001, we recorded $3,190,000, $2,853,000 and $10,664,000 for the amortization of intangible assets with finite lives. The increase of $337,000 in fiscal year 2003 over fiscal year 2002 was attributed to amortization expense on assets acquired from Vultus. The decrease in amortization expense in fiscal year 2002 compared to fiscal year 2001 was primarily attributed to a write-down of goodwill and intangibles in the fourth quarter of fiscal year 2001 that decreased the carrying value of these assets.
Loss on Disposition and Impairment of Long-lived Assets
2003 Change 2002 Change 2001
--------- ------ ----------- ------ ------------
Loss on disposition and
write-down of long-lived
assets $ 164,000 (91 %) $ 1,796,000 (98 %) $ 73,700,000
Percentage of total revenue 0 % 3 % 182 %
During fiscal years 2003 and 2002, we recorded a write down of long-lived assets of $164,000 and $1,796,000, respectively, which primarily related to restructurings that occurred during each fiscal year. During fiscal year 2001, we determined that various long-lived assets were impaired and that the book value as of October 31, 2001 exceeded the current estimates of fair value. As a result, we recorded an impairment of $73,700,000 related to the write-down of long-lived assets of goodwill and intangibles. This impairment was attributable to unanticipated decreases in actual and forecasted revenue of the acquired operations from the Santa Cruz Operation, a significant decline in economic conditions particular in the information technology sector and a weakening of partner relationships. The impairment recorded in fiscal year 2001 significantly reduced the amortizable base of intangible assets with finite lives, which has resulted in lower amortization on intangibles in the 2002 and 2003 fiscal years.
Write-offs of Investments
2003 Change 2002 Change 2001
--------- ------ ----------- ------ -----------
Write-offs of investments $ 250,000 (79 %) $ 1,180,000 (86 %) $ 8,309,000
Percentage of total revenue 0 % 2 % 21 %
Management routinely assesses our investments for impairments and adjusts the carrying amounts to estimated realizable values when impairment has occurred. During fiscal year 2003, in connection with the restructuring of our investment in and relationship with Vista.com ("Vista"), we recorded a write-off our Vista investment and incurred a charge of $250,000. We had been accounting for our investment in Vista under the equity method of accounting.
During fiscal year 2002, we determined that the current carrying value of $1,180,000 related to our investment in Lineo, Inc. would not be recovered and was written-off. This write-off was due to a significant deterioration in the operating results of Lineo and declines in general economic conditions. This investment had been accounted for under the cost method.
During fiscal year 2001, we determined the carrying value of our investments in Troll Tech AS, Evergreen Internet, Inc. and Ebiz Enterprises, Inc. would not be realized. The necessary write-offs were due to declines in general economic conditions and the impact of such declines in the operations of these companies as well as a decline in overall market valuations in these particular industries. As a result, we determined that the current carrying value of these investments would most likely not be recovered and we recorded write-offs of $8,309,000related to these investments. We had accounted for our investments in Troll Tech and Evergreen under the cost method and our investment in Ebiz under the equity method of accounting.
Stock-based Compensation
2003 Change 2002 Change 2001
----------- ------ ----------- ------ -----------
Stock-based compensation $ 1,204,000 7 % $ 1,125,000 (18 %) $ 1,373,000
Percentage of total revenue 2 % 2 % 3 %
In connection with stock options and restricted shares granted to employees and others, we recorded stock-based compensation of $1,204,000 in fiscal year 2003, $1,125,000 in fiscal year 2002, and $1,373,000 in fiscal year 2001. The increase in stock-based compensation in fiscal year 2003 when compared with fiscal year 2002 is primarily attributable to restricted stock grants. The fair value of these restricted stock awards was recorded as a component of stock-based compensation as the restrictions lapsed. We also issued a warrant to a consultant which increased our stock-based compensation in fiscal year 2003.
Compensation to Law Firms
On February 26, 2003, we entered into an arrangement with Boies, Schiller & Flexner LLP and other firms to investigate and review our UNIX intellectual property rights. This arrangement was later modified on November 17, 2003 and December 8, 2003. The engagement with the law firms now includes the defense work related to counter suits and other retaliatory actions against us and lawsuits against end users violating our intellectual property and contractual rights. The law firms are also representing us in our lawsuit against Novell.
In addition to receiving fees at reduced hourly rates, our agreement with the law firms provides that the law firms will receive a contingency fee of 20 percent of the proceeds from specified events related to the protection of our intellectual property rights. These events may include settlements, judgments, certain licensing fees, subject to certain exceptions, and a sale of our company during the pendancy of litigation or through settlement, subject to agreed upon credits for amounts received as discounted hourly fees and unused retainer fees. Additionally, our agreement with the law firms may also be construed to include contingency fee payments in connection with our issuance of equity securities. Future payments payable to the law firms under this arrangement may be significant.
During fiscal year 2003, we incurred a charge of $8,956,000, or 11 percent of revenue, related to this arrangement as contingency fees to these law firms in connection with the issuance of shares of our Series A Convertible Preferred Stock. This charge consisted of a non-cash charge of $7,956,000 related to the issuance of 400,000 shares of our common stock and a $1,000,000 cash payment that was accrued as of October 31, 2003 and paid subsequent to year-end.
In-process Research and Development
In connection with the acquisition of the server and professional services groups of The Santa Cruz Operation, we recorded a charge of $1,500,000, or 4 percent of total revenue, in fiscal year 2001 for the fair value of in-process research and development. The write-off was necessary because the acquired in-process research and development related to UnixWare 7.1.2 and Messaging Server products had not yet reached technological feasibility and had no future alternative uses. Development work on the UnixWare 7.1.2 and Messaging Server products were substantially complete at the end of fiscal year 2001. We did not have any charges for in-process research and development in fiscal years 2003 and 2002.
Cost-sharing Arrangement with The Santa Cruz Operation
After entering into the agreement with The Santa Cruz Operation to acquire the server and professional services groups, we and The Santa Cruz Operation agreed that we would reimburse The Santa Cruz Operation for certain employee payroll and related costs. We viewed these employees as a critical part of the success of the new combined company and The Santa Cruz Operation agreed to retain the employees if we would reimburse The Santa Cruz Operation for a portion of its payroll and related costs. In fiscal year 2001, we reimbursed $602,000, or 1 percent of total revenue, to The Santa Cruz Operation for services rendered under the agreement. We did not have any such charges in fiscal years 2003 and 2002.
Equity in Losses of Affiliate
We account for our ownership interests in companies that 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 entities' net income or net loss in our consolidated statements of operation. During fiscal years 2003, 2002 and 2001, we recorded $62,000, $50,000 and $648,000, respectively, that related to net losses in these entities.
Other Income (Expense), net
Other income (expense), net, which consists principally of interest expense, interest income and the change in fair value of the derivative related to our Series A Convertible Preferred Stock, was $2,827,000 in fiscal year 2003, ($168,000) in fiscal year 2002 and $3,505,000 in fiscal year 2001. During fiscal year 2003, we recorded income of $2,845,000 related to the change in fair value of the derivative related to our Series A Convertible Preferred Stock. Exclusive of this income, our net other expense was ($18,000). The decrease in fiscal years 2003 and 2002 from fiscal year 2001 is primarily attributable to significantly less interest income earned as a result of lower cash balances. Our other income (expense), net, will be unpredictable in future periods because changes in the value of the derivative may be significant and will continue to be recorded until the holders of the Series A Convertible Preferred Stock have converted their shares into shares of our common stock.
Provision for Income Taxes
The provision for income taxes was $774,000 in fiscal year 2003, $483,000 in fiscal year 2002 and $578,000 in fiscal year 2001. The provision for income taxes is primarily related to earnings in foreign subsidiaries. As of October 31, 2003, we had net operating loss carry-forwards for U.S. federal and state income tax reporting purposes of approximately $88,642,000 that expire at various dates between 2018 and 2023. We had net deferred tax assets, including net operating loss carry-forwards and other temporary differences between book and tax deductions, totaling approximately $53,474,000 as of October 31, 2003. We also had net deferred tax liabilities of approximately $566,000 related to taxes on foreign earnings. A valuation allowance in the amount of $52,908,000, the difference between our
deferred tax assets and liabilities, has been recorded as of October 31, 2003 as a result of uncertainties regarding the ultimate realizability of the net deferred tax asset balance.
Dividends Related to Series A Convertible Preferred Stock
On October 16, 2003, we issued 50,000 shares of our Series A Convertible Preferred Stock for $1,000 per share. The net proceeds from the sale of the preferred stock were $47,740,000. The initial value of the preferred stock was bifurcated into two elements consisting of a derivative valued at $18,069,000 and the remaining preferred stock valued at $29,671,000. Dividends will be paid after the first anniversary of the closing and will be paid quarterly at a rate of 8 percent per annum, subject to annual increases of 2 percent per annum, not to exceed 12 percent per annum. Because dividends are not payable during the first year the preferred stock is outstanding, we have accrued dividends of $123,000 for fiscal year 2003, which reduced earnings available to common stockholders.
Quarterly Results of Operations
The following table sets forth certain unaudited quarterly statement of operations data for the last eight quarters. This information has been derived from our unaudited consolidated financial statements, which, in management's opinion, have been prepared on the same basis as the audited financial statements and include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the information for the quarters presented. This information should be read in conjunction with the audited consolidated financial statements and related notes included elsewhere in this Form 10-K. The operating results for any quarter are not necessarily indicative of the operating results for any future period.
Quarter Ended
-------------------------------------------------
January October
31, April 30, July 31, 31,
2003 2003 2003 2003
---------- ------------ -------- ----------
(unaudited)
(In thousands, except per share data)
Fiscal Year 2003
Revenue $ 13,540 $ 21,369 $ 20,055 $ 24,290
Gross margin 10,662 16,222 15,521 16,927
Income (loss) from operations (738 ) 4,925 3,410 (4,161 )
Net income available (loss applicable)
to common stockholders (724 ) 4,500 3,096 (1,568 )
Net income (loss) to per common share:
Basic $ (0.06 ) $ 0.39 $ 0.25 $ (0.12 )
Diluted $ (0.06 ) $ 0.33 $ 0.19 $ (0.12 )
Weighted average basic common shares 11,244 11,561 12,469 13,371
Weighted average diluted common shares 11,244 13,663 16,180 13,371
Quarter Ended
-------------------------------------------------
January October
31, April 30, July 31, 31,
2002 2002 2002 2002
---------- ------------ -------- ----------
(unaudited)
(In thousands, except per share data)
Fiscal Year 2002
Revenue $ 17,913 $ 15,476 $ 15,384 $ 15,468
Gross margin 12,233 10,020 11,313 12,359
Loss from operations (10,914 ) (6,441 ) (4,242 ) (2,579 )
Net loss to common stockholders (11,006 ) (6,631 ) (4,511 ) (2,729 )
Basic and diluted net loss per $ (0.77 ) $ (0.47 ) $ (0.35 ) $ (0.26 )
common share
Weighted average basic and diluted 14,355 14,235 12,714 10,396
common shares
Fluctuations in Quarterly Results
Factors that may affect quarterly results include:
Ί Ί the interest level of solution providers in recommending UNIX business solutions to end users;
Ί Ί the contingency fees we may pay to the law firms representing us in our efforts to establish and enforce our intellectual property rights;
Ί Ί the level, magnitude and timing of SCOsource license revenue;
Ί Ί the introduction, development, timing, competitive pricing and market acceptance of our products and services and those of our competitors;
Ί Ί changes in general economic conditions, such as recessions, that could affect capital expenditures and recruiting efforts in the software industry in general and in the UNIX environments in particular; and
Ί Ί changing business attitudes toward UNIX as a viable operating system alternative to other competing systems, especially Linux, and changes in attitudes resulting from our lawsuits against end users violating our intellectual property and contractual rights and other SCOsource initiatives.
As a result of the factors listed above and elsewhere in the "Forward-Looking Statements and Factors That May Effect Future Results and Financial Condition" and "Risk Factors" sections of this Form 10-K, it is possible that in some future periods our results of operations may fall below management's expectations as well as the expectations of public market analysts and investors. If revenue falls below management's expectations in any quarter and we are unable to reduce spending, our operating results would be lower than expected.
Liquidity and Capital Resources
Our cash balance increased from $6,589,000 as of October 31, 2002 to $64,428,000 as of October 31, 2003. Our working capital increased from a deficit of ($6,332,000) as of October 31, 2002 to $37,168,000 as of October 31, 2003. During fiscal year 2003, we generated positive cash flow from operations for the first time in our operating history. This was achieved through reductions in costs and increased gross margin generated from our UNIX business and significant license revenue generated from our SCOsource business. We also completed the placement of 50,000 shares of our Series A Convertible Preferred Stock for net proceeds of $47,740,000 in October 2003. We intend to use the proceeds from this offering as well as our other cash resources to maintain and enhance our UNIX business and pursue our SCOsource initiatives. We believe that we will have sufficient cash resources to fund our current operations for at least the next twelve months.
Our net cash provided by operations during fiscal year 2003 was $12,087,000. Cash provided by operations was attributable to net income of $5,427,000, non-cash expenses totaled $11,610,000 and changes in operating assets and liabilities of ($4,950,000). Our working capital position increased from a deficit of ($6,332,000) as of October 31, 2002 to $37,168,000 as of October 31, 2003 primarily because of our increase in cash from our private placement. Our long-term liabilities decreased from $1,625,000 to $508,000 during fiscal year 2003.
Cash used in operations during fiscal year 2002 was $10,592,000 and was primarily attributable to the net loss of $24,877,000, partially offset by non-cash expenses of $10,101,000 and cash provided by changes in operating assets and liabilities of $4,184,000. Cash used in operations declined in fiscal year 2002 from fiscal year 2001 primarily attributable to our cost-cutting actions.
Net cash used in operations during fiscal year 2001 was $40,065,000. Cash used in operations was primarily attributable to the net loss of $131,357,000, which was offset by non-cash charges of
$98,810,000. Cash used in operating activities as a result of changes in operating assets and liabilities was ($7,518,000).
Our investing activities have historically consisted of equipment purchases, investing in strategic partners and the purchase and sale of available-for-sale securities. During fiscal year 2003, cash used in investing activities was $5,512,000, which was primarily a result of our purchase of available-for-sale securities of $4,095,000, equipment purchases of $467,000, our investment in non-marketable securities of $950,000. During fiscal year 2004, we may invest in or acquire vertical application providers as part of our strategy to improve our core UNIX business operations.
During fiscal year 2002, cash provided by investing activities was $5,287,000, which was primarily generated from the sale of $5,943,000 of available-for-sale securities, offset by an investment in a non-marketable security of $350,000, cash paid for the purchase of equipment of $206,000 and payment of $100,000 to The Santa Cruz Operation.
Cash provided by investing activities was $23,238,000 during fiscal year 2001. This consisted of $23,005,000 paid, net of cash acquired, for certain acquisitions as well as $1,520,000 paid for the purchase of equipment. The cash uses were offset by proceeds from sales of available-for-sale securities, net of purchases, of $47,763,000.
Our financing activities provided $50,888,000 during the fiscal year 2003 and consisted primarily of net proceeds of $47,740,000 generated from the issuance of 50,000 shares of Series A Convertible Preferred Stock. Additional financing activities included proceeds received from the exercise of stock options of $2,056,000, proceeds from the purchase of shares of common stock by our employees through our employee stock purchase program of $236,000 and proceeds from the issuance of warrants of $856,000.
Our financing activities used $8,998,000 during fiscal year 2002 and consisted primarily of a $5,000,000 payment to retire the note payable to The Santa Cruz Operation and $4,584,000 for the purchase of shares of our common stock held by two investors. These payments were offset by $291,000 of proceeds received from the exercise of stock options and $295,000 received from employees who purchased shares of our common stock through our employee stock purchase program.
During fiscal year 2001, our financing activities provided $602,000 as a result of the exercise of vested stock options of $303,000, the purchase of shares of common stock through our employee stock purchase program of $126,000 and from minority stockholders in our majority-owned Japanese subsidiary of $173,000.
Our Series A Convertible Preferred Stock includes redemption provisions that may be triggered by events beyond our control. These redemption provisions are triggered by events including delisting of our common stock from the Nasdaq SmallCap Market, failure to have the Series A Convertible Preferred Stock investors' Form S-3 registration statement declared effective in a timely manner and other events. These redemption provisions, if triggered, would require us to redeem the then issued and outstanding shares of preferred stock for cash. If we were required to pay cash to the holders of our preferred stock, it could have a material impact on our liquidity, which may require us to obtain additional sources of cash to sustain operations.
Dividends on the Series A Convertible Preferred Stock will begin to accrue after the first anniversary of the closing and will be paid quarterly at a rate of 8 percent per annum, subject to annual increases of 2 percent per annum, not to exceed 12 percent per annum. Because dividends are not payable during the first year the preferred stock is outstanding, we have accrued dividends of $123,000 for fiscal year 2003. Dividends may be paid in cash or additional shares of our Series A Convertible Preferred Stock, subject to certain limitations.
Our net accounts receivable balance increased from $8,622,000 as of October 31, 2002 to $9,282,000 as of October 31, 2003, primarily as a result of higher invoicing in the fourth quarter of
fiscal year 2003 when compared to the fourth quarter of fiscal year 2002. The majority of our accounts receivable are current and our allowance for doubtful accounts was $230,000 as of October 31, 2003, 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 fiscal year 2003 were not significant.
We recently expanded our efforts with the law firms assisting us with our pursuit of our intellectual property claims and currently expect to devote substantially more financial resources to this effort. We expect that legal fees paid to the law firms we have engaged to pursue these claims will increase substantially in fiscal year 2004. To the extent that SCOsource related costs and legal fees exceed our budgeted amounts for fiscal year 2004, our liquidity will be adversely impacted and fewer financial resources will be available for other initiatives such as maintaining and enhancing our UNIX business.
In addition to paying fees at reduced hourly rates to these firms,' our agreement with the law firms provides that we will pay the law firms a contingency fee of 20 percent of the proceeds from specified events related to the protection of our intellectual property rights. These events may include settlements, judgments, certain licensing fees, subject to certain exceptions, and a sale of our company during the pendancy of litigation or through settlement, subject to agreed upon credits for amounts received as discounted hourly fees and unused retainer fees. Additionally, our agreement with the law firms may also be construed to include contingency fee payments in connection with our issuance of equity securities. Future payments payable to the law firms under this arrangement may be significant in future periods, which may have an adverse impact on our liquidity. This arrangement could also impair our ability to raise equity capital in future periods and increase the cost of such equity.
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 fiscal year 2009. In recent corporate restructuring activities, we have partially vacated some of these facilities, but still have contractual obligations to continue to make ongoing lease payments for one facility that will use available cash. We have pursued and will continue to pursue sublease opportunities, as available, to minimize this use of cash; however, we may not be successful in eliminating or reducing cash expenditures for this facility.
The following table summarizes our contractual lease obligations as of October 31, 2003:
Less than More than
Total 1 year 1-3 years 3 years
----------- ----------- ----------- -----------
Operating lease obligations $ 7,917,000 $ 2,736,000 $ 3,829,000 $ 1,352,000
----------- ----------- ----------- -----------
As of October 31, 2003, we did not have any long-term debt obligations, purchase obligations, other long-term liabilities or material capital lease obligations.
Our ability to cut 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 our SCOsource initiatives and in particular any lawsuits against end users violating our intellectual property and contractual rights. Our SCOsource initiatives, particularly lawsuits against such end users, may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products. This would lead to an accelerated decline in our UNIX products and services revenue. If our UNIX products and services revenue is less than expected, our liquidity will be adversely impacted.
In the event that cash required to fund operations and strategic initiatives exceeds our current cash resources 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 our SCOsource initiatives. We may also not be able to raise
capital for any number of reasons including those listed under the section "Risk Factors" below. Our ability to raise additional equity capital is restricted under the terms of our Series A Convertible Preferred Stock. If additional equity financing is available, it may not be available to us on attractive terms and may be dilutive to our existing stockholders. Our ability to raise debt financing is restricted under the terms of our Series A Convertible Preferred Stock. 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.
Recent Accounting Pronouncements
In November 2002, the EITF reached a consensus on EITF No. 00-21, "Revenue Arrangements with Multiple Deliverables." EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue-generating activities. EITF No. 00-21 is effective for interim periods beginning after June 15, 2003. The adoption of this statement did not have a material effect on our financial position and results of operations.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based CompensationTransition and Disclosure," an amendment of FASB Statement No. 123. This Statement amends FASB Statement No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements. We adopted SFAS No. 148 for our fiscal year ended October 31, 2003.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Financial instruments within the scope of SFAS No. 150 will be classified as liabilities and measured at fair value. Many of those instruments were previously classified as equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have an impact on our financial position or results of operations.
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