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| SCOX > SEC Filings for SCOX > Form 10-Q on 14-Jun-2004 | All Recent SEC Filings |
14-Jun-2004
Quarterly Report
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 "Risk Factors" and elsewhere in this Form 10-Q. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto included in this Form 10-Q and our annual report on Form 10-K for the year ended October 31, 2003 filed with the Securities and Exchange Commission, including the audited financial statements and management's discussion and analysis contained therein. All information presented herein is based on the three and six months ended April 30, 2004. 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"), 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 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. On May 16, 2003, our
stockholders approved our corporate name change to The SCO Group, Inc.
Recent Developments. On February 5, 2004, we completed a transaction
pursuant to an exchange agreement among us, BayStar Capital II, L.P. ("BayStar")
and Royal Bank of Canada ("RBC") in which each outstanding share of our
then-outstanding redeemable Series A Convertible Preferred Stock was exchanged
for one share of our new redeemable Series A-1 Convertible Preferred Stock. On
April 15, 2004, we received a redemption notice from BayStar requesting that we
immediately redeem 20,000 Series A-1 shares then held by BayStar. The redemption
notice asserted that BayStar is entitled to redemption of its the Series A-1
shares under the Certificate of Designation, Preferences and Rights for the
Series A-1 shares because we allegedly had breached certain provisions of our
February 5, 2004 exchange agreement. BayStar's redemption notice did not provide
specific information regarding the factual basis for our alleged breaches of the
exchange agreement, but we do not believe we have breached the exchange
agreement. As a result, we do not believe we are obligated to redeem BayStar's
Series A-1 shares.
On May 5, 2004, we received a notice from RBC of its election to convert
10,000 shares of our Series A-1 Convertible Preferred Stock into a total of
740,740 shares of our common stock. Additionally, RBC informed us that it sold
its remaining 20,000 Series A-1 shares to BayStar, making BayStar the sole
holder of all 40,000 outstanding Series A-1 shares.
On May 31, 2004, we entered into an agreement with BayStar to repurchase and retire BayStar's 40,000 Series A-1 shares. Terms of the agreement require us to pay to BayStar $13,000,000 in cash and issue 2,105,263 shares of our common stock, which consideration will be payable and issuable upon the effectiveness of a registration statement covering the resale of the common stock issued to BayStar. In the event that the registration statement is not declared effective by the SEC, the repurchase
transaction with BayStar will not be completed. Upon completion of the repurchase transaction, all Series A-1 shares will be cancelled and retired and the rights and preferences of the Series A-1 shares will be terminated. The transaction will also eliminate BayStar's contractual rights and will include a general release by both parties.
On or about January 20, 2004, we brought suit against Novell, Inc. ("Novell") for slander of title seeking relief for Novell's alleged bad faith efforts to interfere with our copyrights related to our UNIX source code and derivative works and our UnixWare product. In the lawsuit, we request preliminary and permanent injunctive relief as well as damages. Through our claims, we seek to require Novell to assign to us all copyrights that we believe 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. On June 10, 2004, the court issued a memorandum decision and order which denied our motion to remand the case to state court. The memorandum decision also denied Novell's motion to dismiss in part on claims of falsity. However, the court granted Novell's motion to dismiss regarding our allegations of special damages, but granted us 30 days leave to amend our complaint and plead special damages with more specificity.
On or about March 2, 2004, we brought suit against AutoZone, Inc. for its alleged violations of our UNIX copyrights through its use of Linux. Specifically, the lawsuit alleges that AutoZone is infringing our UNIX copyrights by, among other things, running versions of the Linux operating system that contain code, structure, sequence and/or organization from our proprietary UNIX System V code in violation of our copyrights. The lawsuit filed in U.S. District Court in Nevada requests injunctive relief against AutoZone's further use or copying of any part of our copyrighted materials and also requests damages as a result of AutoZone's infringement in an amount to be proven at trial. On April 23, 2004, AutoZone filed a motion to transfer the case to Tennessee or to stay the case. We have filed an opposition to the AutoZone motion and a hearing is currently scheduled for June 21, 2004.
On or about March 3, 2004, we brought suit against DaimlerChrysler Corporation for its alleged violations of its UNIX software agreement with us. Specifically, the lawsuit alleges that DaimlerChrysler breached its UNIX software agreement with us by failing to voluntarily certify by January 31, 2004 its compliance with its UNIX software agreement as required by us. The lawsuit, filed in Oakland County Circuit Court in the State of Michigan, requests the court to declare that DaimlerChrysler has violated the certification requirements of its UNIX software agreement, permanently enjoin DaimlerChrysler from further violations of the UNIX software agreement, issue a mandatory injunction requiring DaimlerChrysler to remedy the effects of its past violations of the UNIX software agreement and award us damages in amount to be determined at trial together with costs, attorneys' fees and any such other or different relief that the Court may deem to be equitable and just. On April 15, 2004, DaimlerChrysler filed a motion to dismiss our claims. We are in the process of preparing our response to DaimlerChrysler's motion and the hearing on this motion is set for July 21, 2004.
On March 10, 2004, our board of directors authorized management, in its discretion, to purchase up to 1,500,000 shares of our common stock over a 24-month period. Shares may be purchased in open market transactions, block purchases or privately negotiated transactions. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes. During the quarter ended April 30, 2004, we purchased 290,000 shares of our common stock in open market purchases for a total cost of $2,414,000.
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. Until fiscal year 2003, the majority of our revenue and our operating expenses were derived from our UNIX business. The following table shows the operating results of the UNIX business (excluding the SCOsource division and corporate costs) for the three and six months ended April 30, 2004 and 2003 (in thousands):
Three Months Ended April
30, Six Months Ended April 30,
--------------------------- ---------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Revenue $ 10,013 $ 13,045 $ 21,449 $ 26,499
Cost of revenue 1,960 2,611 4,148 5,375
------------ ------------ ------------ ------------
Gross margin 8,053 10,434 17,301 21,124
------------ ------------ ------------ ------------
Sales and marketing 4,117 6,045 9,128 12,481
Research and development 2,797 2,528 5,477 5,161
General and administrative 2,392 1,454 4,564 3,093
Other 593 700 1,380 1,400
------------ ------------ ------------ ------------
Total operating expenses 9,899 10,727 20,549 22,135
------------ ------------ ------------ ------------
Loss from operations $ (1,846 ) $ (293 ) $ (3,248 ) $ (1,011 )
------------ ------------ ------------ ------------
Revenue from our UNIX business decreased by $3,032,000, or 23 percent, for the second quarter of fiscal year 2004 compared to the second quarter of fiscal year 2003, and revenue from our UNIX business decreased by $5,050,000, or 19 percent, for the first two quarters of fiscal year 2003 compared to the first two quarters of fiscal year 2004. The revenue from this business has been declining over the last several quarters primarily as a result of increased competition from alternative operating systems, particularly Linux, and lower information technology spending for UNIX products. If we are unable to generate positive cash flow and profitable operations, our UNIX 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 attain profitability in our UNIX division, we have decreased our operating costs and increased our gross margin percentage over the last several quarters. Operating costs for our UNIX division decreased from $10,727,000 for the second quarter of fiscal year 2003 to $9,899,000 for the second quarter of fiscal year 2004, and decreased from $22,135,000 for the first two quarters of fiscal year 2003 to $20,549,000 for the first two quarters of fiscal year 2004. These cost reductions have primarily been attributable to reduced headcount. We have reduced the number of employees in our UNIX division from 329 as of April 30, 2003 to 263 as of April 30, 2004, eliminated redundant facilities
and reduced other discretionary spending while still preserving our worldwide infrastructure. Our gross margin percentage from our UNIX business during these periods was consistently near 80 percent.
Included in operating costs in the above table, under the caption 'Other,' are non-cash charges for the amortization of intangibles. Also during the second quarter of fiscal year 2004, we incurred a charge of $682,000 classified as general and administrative expense that was related to the elimination of certain positions in the UNIX division. We believe that these cuts will enable the UNIX division to generate improved operating results for the last two quarters of fiscal year 2004.
An important initiative for our UNIX division for our 2004 fiscal year will be our continued investment in and commitment to our UNIX operating systems. As part of this initiative, we intend to release new versions of our UnixWare operating system in June 2004 and our OpenServer operating system in the first calendar quarter of 2005 and will provide these products with increased system reliability, backward compatibility with existing applications and software, increased application and hardware support, integrate widely used internet applications and increased 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, but we believe that they will help prolong our UNIX revenue stream for future quarters.
SCOsource Business. During the 2003 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 but 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.In an effort to protect our UNIX intellectual property, we initiated our SCOsource licensing initiatives. These initiatives now include, among others, seeking to enter into license agreements with UNIX vendors and implementing a worldwide program offering SCOsource intellectual property ("IP") licenses to Linux end users allowing them to continue to use our UNIX source code and derivative works found in Linux. Our SCOsource efforts resulted in the execution of two significant vendor license agreements during fiscal year 2003. In the second quarter of fiscal year 2004, we increased our SCOsource sales and marketing efforts as we continue to implement our SCOsource licensing strategies.
The following table shows the operating results of the SCOsource business for the three and six months ended April 30, 2004 and 2003 (in thousands):
Three Months Ended April Six Months Ended April
30, 30,
------------------------- -------------------------
2004 2003 2004 2003
------------ ---------- ------------ ----------
Revenue $ 11 $ 8,250 $ 31 $ 8,250
Cost of revenue 4,484 2,163 7,924 2,163
------------ ---------- ------------ ----------
Gross margin (4,473 ) 6,087 (7,893 ) 6,087
------------ ---------- ------------ ----------
Sales and marketing 581 — 591 —
Research and development 71 — 98 —
General and administrative — — 22 —
Other — — — —
------------ ---------- ------------ ----------
Total operating expenses 652 — 711 —
------------ ---------- ------------ ----------
Income (loss) from operations $ (5,125 ) $ 6,087 $ (8,604 ) $ 6,087
------------ ---------- ------------ ----------
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 generally expect quarterly legal fees and other SCOsource related costs for the last two quarters of fiscal year 2004 will be consistent with the current level of costs incurred in the second quarter of fiscal year 2004. However, legal expenses could increase over time depending on developments in our litigation matters, and certain events may take place that could require us to pay a 20 percent contingency fee to our law firms. These events may include settlements, judgments, 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 our law firms may also be construed to include contingency fee payments in connection with any issuance of our equity securities.
Because of the uncertainties related to our SCOsource business, 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 generated minimal SCOsource revenue in the first and second quarters of fiscal year 2004, but we anticipate that revenue from vendor licenses and IP licenses will increase during the last two quarters of fiscal year 2004.
Critical Accounting Policies
Our critical accounting policies and estimates include the following:
º • º Revenue recognition;
º • º Deferred income taxes and related valuation allowances;
º • º Fair value of derivative financial instrument and Series A-1 Convertible Preferred Stock;
º • º Impairment of long-lived assets; and
º • º 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. We also provide reserves against revenue based on historical trends and experience. To the extent these estimates were incorrect 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 April 30, 2004, our deferred revenue balance was $7,554,000 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 against our entire net deferred tax asset as of October 31, 2003. 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 and Series A-1 Convertible Preferred Stock. On October 16, 2003, we issued 50,000 shares of our redeemable 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. 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 change in fair value of derivative in other income in the statement of operations for fiscal year 2003. As of January 31, 2004, the fair value of the derivative was $11,600,000 and the decrease in fair value of $3,624,000 was recorded as change in fair value of derivative in other income in our condensed consolidated statement of operations for the three months ended January 31, 2004.
On February 5, 2004, we completed an exchange transaction in which each outstanding Series A share was exchanged for one share of our new redeemable Series A-1 Convertible Preferred Stock. We received no additional proceeds in the exchange. The exchange transaction eliminated the derivative related to the Series A shares that was initially recorded as a current liability on our balance sheet and eliminated the charge in our quarterly statements of operations for the change in the fair value of the derivative related to the Series A shares. The derivative was eliminated due to certain rights and privileges included in the new Series A-1 shares, such as voting rights and rights to board representation, among others, that were not included in the Series A shares.
We recorded $2,300,000 as change in fair value of derivative in other income in the second quarter of fiscal year 2004 related to the change in the fair value of the derivative between January 31, 2004 and February 5, 2004, the time at which the exchange agreement was executed. Through the assistance of an independent valuation firm, we determined the fair value of the Series A-1 shares to be $45,276,000 as of February 5, 2004. We recorded a dividend in the second quarter of fiscal year 2004 of $6,305,000 related to the difference between the fair value of the Series A-1 shares and the carrying
value of the previously issued Series A shares and related derivative. This dividend reduced earnings to common stockholders. The estimated fair value of the Series A-1 shares as of February 5, 2004 was calculated using a binomial model. Specific assumptions used included: 2.7 years to maturity, 11 percent equivalent bond yield, risk-free rate of 2.4 percent, volatility of 130 percent.
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 as of April 30, 2004 in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets" and SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," and determined that the goodwill and intangible assets related to the Vultus technology, which we acquired from Vultus, Inc. ("Vultus") in June 2003, had been impaired. We concluded that an impairment-triggering event occurred during the second quarter of fiscal year 2004 as an impending partnership that would solidify the Vultus revenue and cash flow opportunities did not materialize. Additionally, we had a reduction in force that impacted our ability to move the Vultus initiative forward on a stand-alone basis. Consequently, we have concluded that no significant future cash flows related to its Vultus assets would be realized. As a result of these analyses, we wrote-down the carrying value of our goodwill related to the Vultus acquisition from $1,166,000 to $0 and wrote-down intangible assets related to our Vultus acquisition from $973,000 to $0.
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 the carrying value of our intangible assets with finite lives.
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 the three and six months ended April 30, 2004. Our allowance for doubtful accounts, which is determined based on our historical experience and a specific review of customer balances, was $155,000 as of April 30, 2004. 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 six months ended April 30, 2004 and 2003 (in thousands):
Three Months Ended April
30, Six Months Ended April 30,
-------------------------- --------------------------
Statement of Operations Data: 2004 2003 2004 2003
------------------------------------------- ------------ ----------- ------------ -----------
Revenue:
Products $ 8,415 $ 11,122 $ 18,127 $ 22,212
SCOsource licensing 11 8,250 31 8,250
Services 1,711 1,997 3,371 4,447
------------ ----------- ------------ -----------
Total revenue 10,137 21,369 21,529 34,909
------------ ----------- ------------ -----------
Cost of revenue:
Products 901 1,206 1,789 2,392
SCOsource licensing 4,484 2,163 7,924 2,163
Services 1,073 1,778 2,395 3,470
------------ ----------- ------------ -----------
Total cost of revenue 6,458 5,147 12,108 8,025
------------ ----------- ------------ -----------
Gross margin 3,679 16,222 9,421 26,884
------------ ----------- ------------ -----------
Operating expenses:
Sales and marketing 4,698 6,051 9,719 12,491
Research and development 2,868 2,542 5,575 5,192
General and administrative 2,392 1,462 4,586 3,112
Loss on impairment of long-lived assets 2,139 — 2,139 —
Restructuring charges (reversals) — 136 — (116 )
Amortization of intangibles 593 700 1,380 1,400
Stock-based compensation 396 406 598 618
------------ ----------- ------------ -----------
Total operating expenses 13,086 11,297 23,997 22,697
------------ ----------- ------------ -----------
Income (loss) from operations (9,407 ) 4,925 (14,576 ) 4,187
------------ ----------- ------------ -----------
Equity in income (losses) of affiliates 37 (75 ) 74 (100 )
Other income (expense), net 2,422 (48 ) 6,185 (4 )
Provision for income taxes (966 ) (302 ) (1,094 ) (307 )
------------ ----------- ------------ -----------
Net income (loss) (7,914 ) 4,500 (9,411 ) 3,776
Dividends on redeemable convertible (7,045 ) — (7,801 ) —
preferred stock
------------ ----------- ------------ -----------
Net income (loss) applicable to common $ (14,959 ) $ 4,500 $ (17,212 ) $ 3,776
stockholders
------------ ----------- ------------ -----------
THREE AND SIX MONTHS ENDED APRIL 30, 2004 AND 2003
Revenue
Three Months Ended April 30,
-------------------------------------
2004 Change 2003
------------ ------ ------------
Revenue $ 10,137,000 (53 %) $ 21,369,000
Six Months Ended April 30,
-------------------------------------
2004 Change 2003
------------ ------ ------------
Revenue $ 21,529,000 (38 %) $ 34,909,000
Revenue for the second quarter of fiscal year 2004 decreased by $11,232,000, or 53 percent, from the second quarter of fiscal year 2003, and revenue for the first two quarters of fiscal year 2004 decreased by $13,380,000, or 38 percent, from the first two quarters of fiscal year 2003. These decreases were primarily attributable to decreased revenue from our UNIX products and services as a result of competition from other operating systems, primarily Linux, and minimal SCOsource licensing revenue in the second quarter of fiscal year 2004 compared to SCOsource revenue of $8,250,000 in the second quarter of fiscal year 2003.
Revenue generated from our UNIX operating divisions (Americas and International), SCOsource division and other was as follows:
Three Months Ended April 30,
-----------------------------------
2004 Change 2003
----------- ------ -----------
Americas revenue $ 5,807,000 (13 %) $ 6,710,000
Percent of total revenue 57 % 31 %
International revenue 4,206,000 (34 %) 6,335,000
Percent of total revenue 42 % 30 %
SCOsource revenue 11,000 (100 %) 8,250,000
Percent of total revenue 0 % 39 %
Other revenue 113,000 53 % 74,000
Percent of total revenue 1 % 0 %
Six Months Ended April 30,
-------------------------------------
2004 Change 2003
------------ ------ ------------
Americas revenue $ 12,570,000 (10 %) $ 13,974,000
Percent of total revenue 58 % 40 %
International revenue 8,879,000 (29 %) 12,525,000
Percent of total revenue 41 % 36 %
SCOsource revenue 31,000 (100 %) 8,250,000
Percent of total revenue 0 % 24 %
Other revenue 49,000 (69 %) 160,000
Percent of total revenue 1 % 0 %
The decrease in revenue in the Americas UNIX division for the second quarter and first two quarters of fiscal year 2004 compared to the second quarter and first two quarters of fiscal year 2003 was attributable to continued competition from other operating systems, particularly Linux, as well as a decrease in revenue from corporate accounts. The decrease in revenue in the International UNIX division for the second quarter and first two quarters of fiscal year 2004 compared to the second quarter and first two quarters of fiscal year 2003 was primarily related to the negative impact of the European economy as well as from increased competition from other operating system products,
particularly Linux, in Europe and Asia. We anticipate for the remainder of the 2004 fiscal year that UNIX revenue generated by the Americas and the International UNIX divisions will be consistent with or slightly lower than revenue generated by these two divisions in the second quarter of fiscal year 2004 and that the percentage split between these two UNIX divisions will be generally consistent with that in the second quarter of fiscal year 2004.
The decrease in SCOsource licensing revenue in the second quarter and first two quarters of fiscal year 2004 from the comparable period of the prior fiscal year was primarily attributable to minimal vendor licensing revenue in the 2004 fiscal year periods when compared to $8,250,000 in SCOsource revenue in the second quarter and first two quarters of fiscal year 2003. The SCOsource revenue generated in the second quarter and first two quarters of fiscal year 2003 was from two contracts executed with Sun Microsystems ("Sun") and Microsoft Corporation ("Microsoft").
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 have brought against end users violating our intellectual property and contractual rights or as a result of any adverse changes to our UNIX division.
Products Revenue
Three Months Ended April 30,
------------------------------------
2004 Change 2003
----------- ------ ------------
Products revenue $ 8,415,000 (24 %) $ 11,122,000
Percent of total revenue 83 % 52 %
Six Months Ended April 30,
-------------------------------------
2004 Change 2003
------------ ------ ------------
Products revenue $ 18,127,000 (18 %) $ 22,212,000
Percent of total revenue 84 % 64 %
Our products revenue consists of software licenses of our UNIX products, primarily 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 UNIX division and over 90 percent of our revenue in our International UNIX division, and any disruption in our distribution channel could adversely impact our future revenue.
The decrease in products revenue in the second quarter and first two quarters of fiscal year 2004 as compared with the second quarter and first two quarters of fiscal year 2003 was primarily attributable to decreased sales of UnixWare and OpenServer products primarily resulting from increased competition in the operating system market, particularly Linux, and from a decrease in information technology spending for UNIX products. This impact was felt in all of our distribution channels, and we believe that this competition from Linux will continue in future periods.
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 product lines was as follows:
Three Months Ended April 30,
-----------------------------------
2004 Change 2003
----------- ------ -----------
OpenServer revenue $ 4,580,000 (20 %) $ 5,750,000
Percent of products revenue 54 % 52 %
UnixWare revenue 2,425,000 (20 %) 3,017,000
Percent of products revenue 29 % 27 %
Other products revenue 1,410,000 (40 %) 2,355,000
Percent of products revenue 17 % 21 %
Six Months Ended April 30,
------------------------------------
2004 Change 2003
----------- ------ ------------
OpenServer revenue $ 9,782,000 (7 %) $ 10,491,000
Percent of products revenue 54 % 47 %
UnixWare revenue 5,163,000 (28 %) 7,181,000
Percent of products revenue 28 % 32 %
Other products revenue 3,182,000 (30 %) 4,540,000
Percent of products revenue 18 % 21 %
The decreases in OpenServer and UnixWare revenue as well as other products revenue are the result of increased competition in the operating system market, particularly Linux.
SCOsource Licensing Revenue
Three Months Ended April 30,
----------------------------------
2004 Change 2003
---------- ------ -----------
SCOsource licensing revenue $ 11,000 (100 %) $ 8,250,000
Percent of total revenue 0 % 39 %
Six Months Ended April 30,
--------------------------------
2004 Change 2003
-------- ------ -----------
SCOsource licensing revenue $ 31,000 (100 %) $ 8,250,000
Percent of total revenue 0 % 24 %
SCOsource licensing revenue consists of revenue generated from vendor licenses to use our proprietary UNIX System V code as well as IP licenses. SCOsource licensing revenue was $11,000 for second quarter of fiscal year 2004 as compared to $8,250,000 in SCOsource revenue in the second quarter of fiscal year 2003, and SCOsource revenue was $31,000 for the first two quarters of fiscal year 2004 as compared to $8,250,000 in SCOsource revenue for the first two quarters of fiscal year 2003. The SCOsource revenue generated in the second quarter of fiscal year 2003 was from two contracts executed with Sun and Microsoft.
We generated minimal SCOsource revenue in the first and second quarters of fiscal year 2004, but anticipate that revenue from vendor licenses and intellectual property ("IP") licenses will increase during the final two quarters of fiscal year 2004. However, we are unable to predict the amount and timing of revenue from our SCOsource initiatives for future periods because of the uncertainties related to the timing and revenue recognition of SCOsource licensing revenue.
Services Revenue
Three Months Ended April 30,
-----------------------------------
2004 Change 2003
----------- ------ -----------
Services revenue $ 1,711,000 (14 %) $ 1,997,000
Percent of total revenue 17 % 9 %
Six Months Ended April 30,
-----------------------------------
2004 Change 2003
----------- ------ -----------
Services revenue $ 3,371,000 (24 %) $ 4,447,000
Percent of total revenue 16 % 13 %
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 of $286,000, or 14 percent, in the second quarter of fiscal year 2004 as compared to the second quarter of fiscal year 2003 and the decrease in services revenue of $1,076,000, or 24 percent, in the first two quarters of fiscal year 2004 as compared to the first two quarters of fiscal year 2003 was in part due to a decrease in professional services revenue 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 and generally from a decrease in overall UNIX product revenue.
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 with existing UNIX customers. We anticipate our services revenue for the last two quarters of fiscal year 2004 to decline slightly from the revenue generated in the second quarter of fiscal year 2004.
Cost of Products Revenue
Three Months Ended April 30,
----------------------------------
2004 Change 2003
---------- ------ -----------
Cost of products revenue $ 901,000 (25 %) $ 1,206,000
Percentage of products revenue 11 % 11 %
Six Months Ended April 30,
-----------------------------------
2004 Change 2003
----------- ------ -----------
Cost of products revenue $ 1,789,000 (25 %) $ 2,392,000
Percentage of products revenue 10 % 11 %
Cost of products revenue includes primarily overhead costs, manufacturing costs, royalties to third-party vendors and technology costs. Cost of products revenue decreased by $305,000, or 25 percent, in the second quarter of fiscal year 2004 compared to the second quarter of fiscal year 2003 and decreased by $603,000, or 25 percent, in the first two quarters of fiscal year 2004 compared to the first two quarters of fiscal year 2003. This decrease was primarily attributable to reduced product revenue and reduced overhead and manufacturing costs resulting from our cost reduction efforts.
For the last two quarters of fiscal year 2004, we expect the dollar amount of our cost of products revenue to be lower than our cost of products revenue incurred in the second quarter of fiscal year 2004.
Cost of SCOsource Licensing Revenue
Three Months Ended April 30,
----------------------------------
2004 Change 2003
----------- ------ -----------
Cost of SCOsource licensing revenue $ 4,484,000 107 % $ 2,163,000
Percentage of SCOsource licensing revenue 40763 % 26 %
Six Months Ended April 30,
----------------------------------
2004 Change 2003
----------- ------ -----------
Cost of SCOsource licensing revenue $ 7,924,000 266 % $ 2,163,000
Percentage of SCOsource licensing revenue 25561 % 26 %
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 increased significantly in the second quarter and first two quarters of fiscal year 2004 compared to the second quarter and first two quarters of fiscal year 2003. This is primarily the result of increased legal fees incurred in connection with our ongoing litigation with IBM, Novell, AutoZone and DaimlerChrysler as well as for the pursuit of intellectual property licenses. For the last two quarters of fiscal year 2004, we expect our cost of SCOsource licensing revenue to be generally consistent with our cost of SCOsource license revenue generated in the second quarter of fiscal year 2004. However, cost of SCOsource licensing revenue likely 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 could increase over time depending on developments in our ongoing litigation. Legal expenses may also include contingency payments made to the law firms engaged by us to protect our intellectual property rights, which at this time we are unable to predict the amount or timing of such contingency fees. Additionally, 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
Three Months Ended April 30,
-----------------------------------
2004 Change 2003
----------- ------ -----------
Cost of services revenue $ 1,073,000 (40 %) $ 1,778,000
Percentage of services revenue 63 % 89 %
Six Months Ended April 30,
-----------------------------------
2004 Change 2003
----------- ------ -----------
Cost of services revenue $ 2,395,000 (31 %) $ 3,470,000
Percentage of services revenue 71 % 78 %
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 $705,000, or 40 percent, for the second quarter of fiscal year 2004 compared to the second quarter of fiscal year 2003 and decreased by $1,075,000, or 31 percent, for the first and second quarters of fiscal year 2004 compared to the first and second quarters of fiscal year 2003. This decrease was attributable in part to lower services revenue, 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.
For the last two quarters of fiscal year 2004, we expect the dollar amount of our cost of services revenue to be lower than our cost of services revenue incurred in the second quarter of fiscal year 2004.
Sales and Marketing
Three Months Ended April 30,
-----------------------------------
2004 Change 2003
----------- ------ -----------
Sales and marketing expense $ 4,698,000 (22 %) $ 6,051,000
Percentage of total revenue 46 % 28 %
Six Months Ended April 30,
------------------------------------
2004 Change 2003
----------- ------ ------------
Sales and marketing expense $ 9,719,000 (22 %) $ 12,491,000
Percentage of total revenue 45 % 36 %
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 the second quarter of fiscal year 2003 to the second quarter of fiscal year 2004 of $1,353,000, or 22 percent, and the decrease in sales and marketing expense from the first two quarters of fiscal year 2003 to the first two quarters of fiscal year 2004 of $2,772,000, or 22 percent, was primarily attributable to reductions in sales and marketing employees, reduced travel expenses, and lower commissions and lower co-operative advertising costs as a result of lower revenue. Our sales and marketing headcount decreased from 134 as of April 30, 2003, to 82 as of April 30, 2004.
For the last two quarters of fiscal year 2004, we anticipate the dollar amount of sales and marketing expenses will decrease compared to the second quarter of fiscal year 2004.
Research and Development
Three Months Ended April 30,
----------------------------------
2004 Change 2003
----------- ------ -----------
Research and development expense $ 2,868,000 13 % $ 2,542,000
Percentage of total revenue 28 % 12 %
Six Months Ended April 30,
----------------------------------
2004 Change 2003
----------- ------ -----------
Research and development expense $ 5,575,000 7 % $ 5,192,000
Percentage of total revenue 26 % 15 %
Research and development expenses consist of the salaries and benefits of software engineers, consulting expenses as well as corporate allocations. The increase in research and development expense in the second quarter of fiscal year 2004 of $326,000, or 13 percent, compared to the second quarter of fiscal year 2003 and the increase in research and development expense in the first two quarters of fiscal year 2004 of $383,000, or 7 percent, compared to the first two quarters of fiscal year 2003 was primarily attributable to increased personnel and related costs attributable to development work and
enhancements of our two UNIX operating system products, OpenServer and UnixWare. Our research and development personnel increased from 70 as of April 30, 2003, to 85 as of April 30, 2004.
For the last two quarters of fiscal year 2004, we anticipate the dollar amount of research and development expenses will decrease compared to the second quarter of fiscal year 2004 due to recently implemented cost reductions.
General and Administrative
Three Months Ended April 30,
----------------------------------
2004 Change 2003
----------- ------ -----------
General and administrative expense $ 2,392,000 64 % $ 1,462,000
Percentage of total revenue 24 % 7 %
Six Months Ended April 30,
----------------------------------
2004 Change 2003
----------- ------ -----------
General and administrative expense $ 4,586,000 47 % $ 3,112,000
Percentage of total revenue 21 % 9 %
General and administrative expenses consist of the salaries and benefits of finance, human resources and executive management and expenses for professional services as well as corporate allocations. Included in general and administrative expenses for the three and six months ended April 30, 2004 are $682,000 in payments made in connection with the elimination of approximately 16 percent of our workforce. The increase in general and administrative expense from the second quarter and first two quarters of fiscal year 2003 of $930,000 and $1,474,000, respectively, compared to the second quarter and first two quarters of fiscal year 2004, exclusive of the above mentioned termination payments, was primarily attributable to new compliance and reporting regulations under the Sarbanes-Oxley Act of 2002 and other new regulatory requirements, increased legal costs as a result of corporate legal matters and other legal and professional costs not categorized as SCOsource cost of revenue.
For the last two quarters of fiscal year 2004, we anticipate the dollar amount of general and administrative expenses will decrease compared to the second quarter of fiscal year 2004 due to recently implemented cost reductions.
Restructuring Charges (Reversals)
Three Months Ended April 30,
-------------------------------------
2004 Change 2003
----- ---------- --------------
Restructuring charges (reversals) $ — n/a $ 136,000
Percentage of total revenue 0 % 1 %
Six Months Ended April 30,
--------------------------------
2004 Change 2003
----- --------- ----------
Restructuring charges (reversals) $ — n/a $ (116,000 )
Percentage of total revenue 0 % (0 )%
In March 2003, in connection with management's decision to establish strategic European headquarters in Dublin, Ireland, and our United Kingdom ("UK") subsidiary, SCO Group, Ltd., not performing at expected levels, we determined that SCO Group, Ltd would be wound up. On March 26, 2003, the board of directors of SCO Group, Ltd., obtained administrative relief in accordance with
Rule 2.2 of the Insolvency Rules 1986 of the UK. In connection with the approved administrative relief, the operations of SCO Group, Ltd. were transferred to an administrator that was appointed by the court to complete the winding-up process. As of April 30, 2003, the operations of SCO Group, Ltd. were no longer under our control. The winding-up of SCO Group, Ltd. resulted in a net restructuring charge during the quarter ended April 30, 2003 of $136,000. The net reversal for the first two quarters of fiscal year 2003 was a result of the restructuring charge discussed above related to our UK subsidiary and additional adjustments to previously recorded restructuring charges for actual payments made.
Amortization of Intangibles
Three Months Ended April 30,
----------------------------------
2004 Change 2003
----------- ------ ---------
Amortization of intangibles $ 593,000 (15 %) $ 700,000
Percentage of total revenue 6 % 3 %
Six Months Ended April 30,
-----------------------------------
2004 Change 2003
----------- ------ -----------
Amortization of intangibles $ 1,380,000 (1 %) $ 1,400,000
Percentage of total revenue 6 % 4 %
Amortization of intangibles is the expensing of previously recorded amounts for assets recorded in prior acquisitions with finite lives. The decrease in amortization of intangibles of $107,000 for the second quarter of fiscal year 2004 compared to the second quarter of fiscal year 2003 was primarily attributable to reduced amortization expense recorded on certain assets and technology acquired from The Santa Cruz Operation (now Tarantella, Inc.).
Loss on Impairment of Long-lived Assets
We recorded a loss on impairment of long-lived assets totaling $2,139,000 for the second quarter and first two quarters of fiscal year 2004. The impairment related to goodwill and intangible assets acquired in connection with our acquisition of Vultus in June 2003. We concluded that an impairment triggering event occurred during the three months ended April 30, 2004 as an impending partnership that would solidify the Vultus revenue and cash flow opportunities did not materialize. Consequently, we have concluded that no significant future cash flows related to our Vultus assets will be realized. We performed an impairment analysis of our recorded goodwill related to the Vultus reporting unit in accordance with SFAS No. 142. Additionally, an impairment analysis of the intangible assets was performed in accordance with SFAS No. 144. As a result of these analyses, we wrote-down the carrying value of our goodwill related to our Vultus acquisition from $1,166,000 to $0, and wrote-down the intangible assets related to our Vultus acquisition from $973,000 to $0. We did not incur any impairment charges in the second quarter or first two quarters of fiscal year 2003. We did not have any losses on the impairment of long-lived assets during the second quarter or first two quarters of fiscal year 2003.
Stock-based Compensation
Three Months Ended April 30,
----------------------------------
2004 Change 2003
----------- ------ ---------
Stock-based compensation $ 396,000 (2 )% $ 406,000
Percentage of total revenue 4 % 2 %
Six Months Ended April 30,
--------------------------------
2004 Change 2003
---------- ------ ---------
Stock-based compensation $ 598,000 (3 )% $ 618,000
Percentage of total revenue 3 % 2 %
Stock-based compensation consisted of the following components for the three and months ended April 30, 2004 and 2003 (in thousands):
Three Months Ended Six Months Ended
April 30, April 30,
------------------ ------------------
2004 2003 2004 2003
------- ------- ------- -------
Amortization of stock-based compensation $ 113 $ 239 $ 223 $ 396
Options and shares for services 283 167 283 222
Modifications to options — — 92 —
------- ------- ------- -------
Total $ 396 $ 406 $ 598 $ 618
------- ------- ------- -------
Equity in Income (Losses) of Affiliates
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 condensed consolidated statements of operations. During the second quarter and first two quarters of fiscal year 2004 we recorded income of $37,000 and $74,000, respectively, primarily related to income from our joint venture in China compared to a loss of $75,000 and $100,000, respectively, in the second quarter and first two quarters of fiscal year 2003 primarily related to our investment in Vista, Inc. ("Vista"). We disposed of our investment in Vista in fiscal year 2003.
Other Income (Expense), net
Other income (expense) consisted of the following components for the three and six months ended April 30, 2004 and 2003 (in thousands):
Three Months Ended April Six Months Ended April
30, 30,
------------------------- -------------------------
2004 2003 2004 2003
-------------- ------- -------------- -------
Interest income $ 242 $ 11 $ 512 $ 50
Change in fair value of derivative 2,300 — 5,924 —
Other expense, net (120 ) (59 ) (251 ) (54 )
-------------- ------- -------------- -------
Total other income (expense), net $ 2,422 $ (48 ) $ 6,185 $ (4 )
-------------- ------- -------------- -------
Interest income increased by $231,000 for the second quarter of fiscal year 2004 compared to the second quarter of fiscal year 2003 and increased by $462,000 for the first two quarters of fiscal year 2004 compared to the first two quarters of fiscal year 2003 as a result of interest earned on higher cash
balances. The income recorded of $2,300,000 on the change in fair value of the derivative related to the now-exchanged Series A shares for the second quarter of fiscal year 2004 which represented the change in fair value between February 5, 2004 (the date of the exchange of all Series A shares for Series A-1 shares) and January 31, 2004. For the first quarter of fiscal year 2004, we recorded income of $3,624,000 for the change in fair value of the derivative between October 31, 2003 and January 31, 2004.
Provision for Income Taxes
The provision for income taxes was $966,000 in the second quarter of fiscal year 2004 and $302,000 in the second quarter of fiscal year 2003 and $1,094,000 for the first two quarters of fiscal year 2004 and $307,000 for the first two quarters of fiscal year 2003. The increase in the provision for income taxes for the second quarter and first two quarters of fiscal year 2004 compared to the second quarter and first two quarters of fiscal year 2003 was primarily attributable to accruals for withholding taxes that are estimated to be paid in connection with the operations of the Indian branch of our United Kingdom subsidiary, SCO Group, Ltd.
During the three months ended April 30, 2004, the Indian branch received a withholding tax assessment from the Government of India Income Tax Department ("Tax Department") for the period of April 2000 through March 2001. During the April 2000 through March 2001 period, SCO Group, Ltd. was owned by The Santa Cruz Operation (now Tarantella, Inc.), and not us. We acquired SCO Group, Ltd. in May 2001 as part of an asset purchase.
The Tax Department assessed SCO Group, Ltd. with a 15 percent withholding tax on certain revenue transactions in India that the Tax Department deemed royalty revenue under the Indian Income Tax Act. The total amount of the withholding tax is $396,000. We were not aware of this liability until March 2004, when we received the formal tax assessment from the Tax Department, as we believed that we had been appropriately accounting for the revenue and related taxes on transactions in India.
We have filed an appeal with the Tax Department and believe that our packaged software does not qualify for "royalties" treatment and would therefore not be subject to withholding tax. Additionally, as described above in this Item 2., under the caption "Restructuring Charges (Reversals)," SCO Group, Ltd, the company on which the assessment was levied, has filed for bankruptcy in the UK. Although we intend to vigorously defend this tax assessment, there can be no assurance we will prevail against the Tax Department.
We have recorded the charge for $396,000 in the in the second and first two quarters of fiscal year 2004 as a component of our provision for income taxes. In addition, we believe that the Tax Department probably will pursue similar assessments on SCO Group, Ltd. for taxable periods subsequent to March 2001. Because of this probability, and our inability to determine at this point if we may prevail against the Tax Department, we have accrued the full amount of the estimated withholding tax of $314,000 for these subsequent periods as provision for income taxes in our statements of operations for the second quarter and first two quarters of fiscal year 2004.
Dividends Related to Redeemable Convertible Preferred Stock
In connection with completing the February 5, 2004 exchange of Series A-1 shares for Series A shares, we removed the carrying value of the Series A shares and related derivative and recorded the fair value of the Series A-1 shares issued in the exchange transaction. The difference between these two amounts was $6,305,000 and was recorded as a non-cash dividend for the second quarter and first two quarters of fiscal year 2004.
Additionally, with respect to the Series A-1 shares currently outstanding, dividends will begin to accrue from October 16, 2004, the first anniversary of our original October 16, 2003 private placement of Series A shares, and will be paid quarterly beginning in the 30-day period following January 31, 2005 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 on the Series A-1 shares are not payable until after January 31, 2005, we have accrued dividends of $756,000 for the first quarter of fiscal year 2004 and an additional $740,000 in dividends for the second quarter of fiscal year 2004. We had no dividends accrued or payable in the second quarter or first two quarters of fiscal year 2003. If we repurchase the outstanding Series A-1 shares as contemplated in our May 31, 2004 agreement with BayStar as described in more detail above in this Item 2., under the caption "Recent Developments," then we will not be obligated to pay such dividends on the Series A-1 shares.
Liquidity and Capital Resources
Our cash and equivalents and available-for-sale securities balances decreased from $68,523,000 as of October 31, 2003 to $61,346,000 as of April 30, 2004; however, our working capital increased from $37,168,000 as of October 31, 2003 to $39,556,000 as of April 30, 2004. Our cash and equivalents decreased from $64,428,000 as of October 31, 2003 to $45,696,000 as of April 30, 2004, primarily as a result of cash used in operations, principally from our SCOsource division, and cash used to purchase available-for-sale securities.
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 our private placement of 50,000 Series A shares for net proceeds of $47,740,000 in October 2003, which shares were exchanged for Series A-1 shares in February 2004. If we repurchase the outstanding Series A-1 shares from BayStar pursuant to our May 31, 2004 agreement, then the net proceeds received in our private placement would be reduced by the $13,000,000 cash component of the repurchase price. We intend to use the net proceeds from our preferred stock financing as well as our other cash resources to pursue our SCOsource initiatives. We believe that we will have sufficient cash resources to complete the Series A-1 repurchase transaction and fund our current operations for at least the next 12 months.
Our net cash used in operations for the first two quarters of fiscal year 2004 was $5,206,000 compared to cash generated from operations of $3,173,000 for the first two quarters of fiscal year 2003. Cash used in operations in the first two quarters of fiscal year 2004 included a net loss of $9,411,000, non-cash expenses of $1,280,000 and changes in operating assets and liabilities of $5,485,000. Our current liabilities decreased from $45,112,000 as of October 31, 2003 to $34,335,000 as of April 30, 2004 primarily related to the elimination of the fair-value of the derivative related to our now-exchanged Series A shares and the decrease in accrued compensation to law firms, which were offset by an increase in accrued liabilities.
Our investing activities have historically consisted of equipment purchases, investing in strategic partners and the purchase and sale of available-for-sale securities. During the first two quarters of fiscal year 2004, cash used in investing activities was $11,950,000, which was primarily a result of our purchase of available-for-sale securities (net of sales) of $11,555,000, equipment purchases of $186,000 and cash used to acquire the outstanding minority interest in our Japanese subsidiary of $209,000. Cash used in investing activities was $778,000 for the first two quarters of fiscal year 2003 and primarily attributable to equipment purchases of $328,000 and the investment in non-marketable securities of $450,000.
Our financing activities used $1,697,000 during the first two quarters of fiscal year 2004 and consisted primarily of cash used to purchase shares of our common stock on the open market of
$2,414,000 and cash used to exchange Series A-1 for Series A shares of $212,000. These uses of cash were offset from proceeds received from the exercise of stock options of $559,000 and proceeds from the purchase of shares of common stock by our employees through our employee stock purchase program of $370,000. Cash provided by financing activities was $782,000 for the first two quarters of fiscal year 2003 and was attributable to proceeds received from the exercise of stock options of $225,000, the issuance of a warrant of $500,000 and proceeds from the purchase of shares of common stock by our employees through our employee stock purchase program of $57,000.
The Certificate of Designation, Rights and Preferences creating our Series A-1 shares includes redemption provisions that, if triggered, would require us to repurchase for cash the outstanding shares of our Series A-1 shares. Our redemption obligation may be triggered by certain events including, among others, our company or any of its subsidiaries making an assignment for the benefit of creditors or consenting to the appointment of a trustee or receiver for it or a substantial part of its business, the bankruptcy, reorganization, liquidation or similar proceedings instituted by or against our company or any of its subsidiaries, a change in control event occurring with respect to our company or our failure to pay when due any indebtedness in excess of $1,000,000 or otherwise our default under any agreement binding us that would likely result in a material adverse effect on our business.
As stated above in this Item 2., under the caption "Recent Developments," on April 15, 2004, we received a redemption notice from BayStar requesting that we immediately redeem 20,000 shares of our Series A-1 shares then held by BayStar. The redemption notice asserted that BayStar is entitled to redemption of its shares under the Certificate of Designation for the Series A-1 shares because we allegedly had breached certain provisions of our February 5, 2004 exchange agreement relating to our exchange of Series A shares for Series A-1 shares. BayStar's redemption notice did not provide specific information regarding the factual basis for our alleged breaches of the exchange agreement, but we do not believe we have breached the Exchange Agreement. As a result, we do not believe we are obligated to redeem BayStar's Series A-1 shares. However, if we were required to pay cash to redeem BayStar's Series A-1 shares pursuant to the redemption notice or otherwise pursuant to the Certificate of Designation for the Series A-1 shares, it would have a material and adverse impact on our liquidity, which may require us to obtain additional sources of cash to sustain operations.
Dividends on our Series A-1 shares, if not repurchased pursuant to our May 31, 2004 stock repurchase agreement with BayStar, will begin accruing from October 16, 2004 and will be paid quarterly beginning in the 30-day period following January 31, 2005 at a rate of 8 percent per annum, subject to annual increases of 2 percent per annum, not to exceed 12 percent per annum. Dividends may be paid in cash or additional Series A-1 shares, subject to certain limitations.
If we do complete our previously announced Series A-1 share repurchase transaction with BayStar, we will pay to BayStar $13,000,000 in cash and issue 2,105,263 shares of our common stock, payable and issuable upon the effectiveness of a shelf registration statement for the resale of the common stock issued to BayStar. The payment to BayStar will have a negative impact on our cash and working capital position, but will eliminate all remaining issued and outstanding Series A-1 shares and associated rights and preferences related to dividends, liquidation payments, voting and others.
Our net accounts receivable balance decreased by $2,471,000 from $9,282,000 as of October 31, 2003 to $6,811,000 as of April 30, 2004. This decrease was primarily attributable to the collection of year-end receivables and lower overall invoicing during the second quarter of fiscal year 2004. The majority of our accounts receivable are current and our allowance for doubtful accounts was approximately $155,000 as of April 30, 2004, which represented approximately 2 percent of our gross accounts receivable balance. This allowance as a 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 second quarter of fiscal year 2004 were not significant.
During fiscal year 2003, we 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. 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, which may harm our results of operations as we anticipate that these costs to the law firms will be expensed as incurred.
We expect that legal fees for the last two quarters of fiscal year 2004 paid to the law firms we have engaged to pursue our intellectual property claims will be consistent to the level of fees incurred during the second quarter of fiscal year 2004. However, legal expenses could increase over time depending on developments in litigation involving us, and certain events outside of our control could occur or certain contingent events could take place that would require us to pay additional fees to the law firms. To the extent that our SCOsource related costs and legal fees exceed our budgeted amounts in future quarters of fiscal year 2004 or SCOsource revenue is below our expectations, our liquidity will be adversely impacted and fewer financial resources will be available for other initiatives such as maintaining and enhancing our UNIX business. Additionally, future contingency fees payable to the law firms may be significant in future periods, which may have an adverse impact on our liquidity. Our compensation arrangement with our law firms could also impair our ability to raise equity capital in future periods.
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 2010. In corporate restructuring activities during fiscal years 2001 through 2003, we 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 April 30, 2004:
Less than More than
Total 1 year 1 - 3 years 3 years
----------- ----------- ------------ ----------
Operating lease obligations $ 6,748,000 $ 2,702,000 $ 3,277,000 $ 769,000
----------- ----------- ------------ ----------
As of April 30, 2004, we did not have any long-term debt obligations, purchase obligations or material capital lease obligations.
Our ability to cut costs to offset revenue declines in our UNIX business is limited to a certain extent because of contractual commitments to maintain and support our existing UNIX customers. The decline in our UNIX business may be accelerated if industry partners withdraw their support as a result of 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 may 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-1 shares. 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-1 shares. 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.
On March 10, 2004, our board of directors authorized management, in its discretion, to purchase up to 1,500,000 shares of our common stock over a 24-month period. Shares may be purchased in open market transactions, block purchases or privately negotiated transactions. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes. During the second quarter of fiscal year 2004, a total of 290,000 shares of our common stock were repurchased for a total of $2,414,000. If we continue to repurchase a substantial number of shares during this 24-month period, and we do not generate off-setting revenue form our UNIX and SCOsource businesses, our cash position could decrease significantly and our ability to fund future operations could be adversely impacted. Purchases under stock repurchase program are subject to the discretion of management based on market conditions and other factors including the trading price of our common stock, availability of stock, alternative uses of capital and our financial condition.
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