UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended October 31, 2006

For the transition period from                      to                     .

     Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES o NO þ

     Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES o NO þ

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

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference on Part III of this Form 10-K or any amendment to this Form 10-K. o

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

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

     The aggregate market value of the common stock held by non-affiliates of the Registrant was approximately $42,410,000 based on the reported last sale price of common stock on April 30, 2006, which was the last business day of the Registrant’s most recently completed second fiscal quarter.

     The number of shares of the Registrant’s common stock outstanding as of January 24, 2007, was 21,230,465.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the Registrant’s proxy statement to be filed pursuant to Regulation 14A in connection with its 2007 annual meeting of stockholders are incorporated by reference into Part III of this Form 10-K.

 

Item 1. Business

     The Business section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain forward-looking statements relating to our business and strategy. These forward-looking statements involve risks and uncertainties. Many forward-looking statements are located in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of this Form 10-K. 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 in the section entitled “Risk Factors” under Part I, Item 1A of this Form 10-K. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

     As used in the Form 10-K, “SCO” and “OpenServer” are trademarks or registered trademarks of our Company in the United States and other countries. “UNIX” and “UnixWare” are registered trademarks of The Open Group in the United States and other countries. All other brand or product names are or may be trademarks of, and are used to identify the products and services of, their respective owners. As used herein, the “Company” or “us,” “we,” “ours,” or similar terms refer to The SCO Group, Inc. and our operating subsidiaries.

Overview

     We own the base UNIX operating system technology and are a provider of UNIX-based products and services. Our core business is to sell and service our UNIX software products to small-to-medium sized businesses and franchisees or branch offices of Fortune 1000 businesses. The products that drive the majority of our UNIX revenue are OpenServer and UnixWare. We intend to continue to develop, market and service our UNIX products and services during the year ending October 31, 2007 while at the same time further developing and marketing our mobility products and services for personal and professional productivity.

     We developed our SCOsource business as part of our ongoing efforts to establish and protect our intellectual property rights, particularly relating to our ownership of the original UNIX source code. This business’ primary objective is to protect and defend our UNIX intellectual property rights. In reviewing our intellectual property rights during the year ended October 31, 2003, we became aware that parts of, or modifications made or relating to, our UNIX source code and derivative works have been included in the Linux operating system without our authorization or appropriate copyright attribution.

UNIX Business

     Our core business focus is to serve the needs of small-to-medium sized businesses and branch offices and franchisees of Fortune 1000 companies, by providing reliable, cost-effective UNIX software technology for distributed, embedded and network-based systems. We also provide a full range of pre- and post-sales technical support for all of our products, primarily focusing on OpenServer and UnixWare. Additionally, we provide UNIX-based technical support services and consulting services.

     Our largest source of revenue for our core UNIX business is derived from our worldwide, indirect, leveraged channel of partners, which includes distributors and independent solution providers (collectively, “resellers”). We have employees or contractors in a number of countries that provide support and services to customers and resellers. The other principal channel for selling and marketing our products is through large corporations, which have a large number of branch offices or franchisees. We access these corporations through their information technology or purchasing departments. In addition, we also sell our UNIX products to original equipment manufacturers (“OEMs”).

     The original UNIX operating system, which we own, was conceived on the premise that an operating system should be easily adapted to a broad range of hardware platforms and should provide a simple way of developing programs. Over the years, the UNIX operating system has been adapted for almost every OEM’s hardware architecture, and today UNIX has achieved the goal of seamlessly sharing data across heterogeneous environments. We own a broad and deep set of intellectual property rights relating to the UNIX operating system, which we intend to continue to enforce and protect through our SCOsource business.

     UNIX has had a long history of business implementation, and has a large and loyal base of both customers and vendors that provide solutions and applications. On the Intel platform, our OpenServer and UnixWare products represent a low-cost UNIX operating system available for businesses. Our UNIX product offerings allow our customers to take advantage of the reliability of UNIX at a relatively low cost. Today, we continue to focus and generate revenue from small-to-medium business resellers as well as from large corporations, including numerous Fortune 1000 companies. We also have continuing relationships with hardware vendors and have received certifications on many of the industry’s top hardware platforms.

     Sales of our UNIX-based products and services have been declining over the last several years. This decline in revenue has been primarily attributable to significant competition from alternative operating systems, particularly Linux.

     We anticipate that our OpenServer and UnixWare products will continue to provide a future revenue stream for our UNIX business. However, unless there is a change in the current operating system environment, we expect revenue from these products will continue to decline. Both of these UNIX products have a strong and loyal existing customer base of small-to-medium businesses and enterprise customers and constitute a well-known brand with a reputation for quality and reliability.

     We also have a seasoned, mature sales channel of resellers focused on the small-to-medium sized business market. This channel is a unique asset that should allow us to continue to provide reliable UNIX operating systems for small-to-medium sized business customers.

     For the upcoming fiscal year ending October 31, 2007, we plan to continue to focus our UNIX development resources on our current UNIX products. In addition, we will focus other engineering resources on our mobility products and services for personal and professional productivity. We expect that these mobility products and services will enable easy, secure, real-time mobile access to all kinds of information stored in enterprise and web-based systems without the need for direct connection between end-point devices and those systems.

     Our research and development efforts are described in more detail below in the subsection entitled “Software Engineering and Development.”

     We face direct competition in the operating system market from Linux operating system providers, other non-UNIX operating system providers and other UNIX-based operating system providers. In the operating system market, some of our competitors include International Business Machines Corporation (“IBM”), Red Hat Inc. (“Red Hat”), Novell Inc. (“Novell”), Microsoft Corporation (“Microsoft”), and Sun Microsystems (“Sun”). Operating systems, including Linux, are aggressively taking market share away from UNIX and our UNIX revenue has declined over the last several years.

     We believe that we compete favorably with many of our operating system competitors in a number of respects, including product performance, functionality and networking capability.

Notwithstanding these factors, our revenue has declined over the last several years. Many of our competitors are significantly larger than we are and have much greater access to funding, technical expertise, marketing, and research and development. In addition, many of our competitors have established brand recognition and market presence that may prevent us from obtaining or retaining market share. Additionally, the assertion of our legal rights relating to our UNIX ownership and related copyrights and our other legal actions have resulted in us becoming the focus of a significant amount of negative publicity from various sources that has to some degree, hampered our ability to compete favorably.

     The success of our UNIX business will, in large measure, depend on the level of commitment and certification we receive from industry partners and developers. In recent years, we have seen hardware and software vendors as well as software developers turn their certification and application development efforts toward Linux and elect not to continue to support or certify to our UNIX operating system products. This trend continued for the year ended October 31, 2006, and we believe that it will continue during the year ending October 31, 2007. If this trend does continue as expected, our competitive position will be adversely impacted and our future revenue from our UNIX business will decline, possibly at an even faster rate than it has declined over the last several years. The decline in our UNIX business may be accelerated if industry partners withdraw their support from us as a result of the litigation between the Company and IBM, Novell and Red Hat (the “SCO Litigation”).

     The market for mobility products and services is relatively young, and we believe it is poised for rapid growth. Competition is strong and takes numerous forms, including database vendors who are providing mobile extensions of their current offerings as well as start-up companies and other large corporations who are focusing on custom solutions based on proprietary middleware. We believe that the landscape and competition will change rapidly and that no single company has established firm leadership. The success of our mobility products and services offerings will depend in part, on the level of commitment and resources we are able to devote to these offerings, the partnerships we are able to establish, our ability to attract and retain new customers and partners, and the strength of our mobility offerings.

     OpenServer. OpenServer is our UNIX-based offering targeted at small-to-medium businesses. Businesses use OpenServer to simplify and speed business operations, better understand and respond to their customers’ needs and achieve a competitive advantage. OpenServer excels at running multi-user, transaction and business applications, communications gateways, and mail and messaging servers in both host and client/server environments. We continue to fully support existing users of OpenServer, keeping the operating system current as well as obtaining certain hardware certifications. The latest release, OpenServer 6, began shipping in June 2005.

     UnixWare. UnixWare is our UNIX-based offering targeted at medium-size businesses and enterprise customers. UnixWare is an advanced deployment platform for industry standard Intel processor systems. UnixWare is a foundation for solutions where proven scalability, reliability and affordability are critical. UnixWare includes enhancements and refinements to the UNIX platform, representing added value for existing UnixWare customers. The latest release of UnixWare, UnixWare 7.1.4, began shipping in May 2004.

     Other Products. In addition to OpenServer and UnixWare, we offer product maintenance and additional UNIX-related products, such as SCOoffice Server, a UNIX-based e-mail and collaboration system and other UNIX system add-ons.

     Technical Support Services. We provide a full range of pre- and post-sale technical support for all of our products, primarily focusing on OpenServer and UnixWare.

     We also provide technical support to our partners, including resellers, hardware and software vendors and solution providers, as well as directly supporting our end-user customers. Our partners have the option to direct their customers to us for technical support or to provide first-level customer support themselves and utilize our technical expertise for second-tier support.

     Technical support services include a range of options from single incident e-mail and telephone support to dedicated “enterprise” level support agreements. Customers seeking additional technical support directly from us may enter into service agreements that best suit their needs.

     Other Services. Our other services include software development and programming, migration tools and services and assisting customers with modernizing and integrating legacy applications with web services. We assist our end-user customers and solution providers in planning, creating, implementing and deploying business application solutions.

     Mobility Products and Services. Our new Mobility Server product provides a secure, reliable connection point between handheld devices and corporate infrastructure applications and servers; a HipCheck Service which enables pro-active mobile administration for UNIX and Windows servers; a Shout product which enables users to communicate multimedia messaging to groups of any size via a mobile smart phone or rich media web landing page; and a Shout Postcard product which allows users to send virtual postcards from their smart phone.

     We have business alliances with a number of key global industry partners. These relationships encompass product integration, two-way technology transfers, product certification, channel partnerships and revenue generating initiatives in areas of product bundling, OEM agreements and training and education. The objectives of these partnerships include providing complete hardware and software UNIX solutions and mutually developing our sales and distribution channel by coordinating marketing initiatives in creating awareness for our products. We also have alliances with a number of solution providers who write and develop custom applications to run on UNIX operating systems. Most of our small business customers that cannot afford high-end solutions or an information technology staff rely on one of our channel partners for these services. Maintaining these strategic alliances for the year ending October 31, 2007 will be critical to the success of our UNIX business. We intend to continue to keep relationships with key partners in certain vertical markets such as retail, medical/pharmaceutical, manufacturing and accounting where our UNIX operating systems have an existing presence. Our efforts to maintain or expand industry partnerships may be adversely impacted by issues related to the SCO Litigation.

     Our UNIX sales and marketing and field operations are organized by geographic area: our Americas division and our International division. Each division includes a sales organization, field marketing, pre- and post-sales technical support, and local professional services personnel.

     Americas. The Americas team has field sales and support personnel located around the United States, Latin America and Canada. This region delivered approximately 54% of the total revenue for the year ended October 31, 2006. The sales team is organized into Area Sales Managers (“ASMs”), who each manage a specific geographic area and support our resellers and channel partners as well as service our corporate account customer base, including OEM partners. ASMs have the following specific roles:

     International. The International region delivered approximately 46% of the total revenue for the year ended October 31, 2006 and includes EMEA (Europe, the Middle East and Africa) and Asia Pacific. We have resources, employees or contractors in the United Kingdom, Germany, France, Israel, Italy, China, Korea, Netherlands, Eastern Europe, India, Japan, Australia, and Taiwan. The country sales teams perform the same functions as the Americas sales team, including channel sales, corporate account sales and OEM sales. In the International division, particularly in smaller countries, one sales representative will manage both channel and major account sales within that country. The International division also uses local distributors in each location to process all channel orders.

     We consider our indirect sales channel one of our most valuable assets. In addition to the current revenue this channel produces, our reseller partners are valuable for the influence they wield on the purchasing decisions of small and medium businesses. Our resellers are often not only the primary point of contact for their business customers’ purchasing decisions, but are their customers’ outsourced information technology department. The reach of our network of resellers into the small and medium business community is broad as evidenced by our large install base of servers running various versions of our OpenServer and UnixWare operating systems. A key to our future success will be our ability to provide additional products and services to our reseller channel and to communicate our product and corporate strategy to these resellers.

     Our marketing efforts support our sales and distribution efforts, promotions and product introductions, and include marketing activities to promote our UNIX and mobile products. Marketing is focused on branding, solutions, advertising, tradeshows, press releases, white papers and marketing literature. In particular, our marketing strategy consists of:

     Information regarding financial data by segments, geographic regions and long-lived assets is set forth in Part II, Item 8 of this Form 10-K in Note 13 to the consolidated financial statements.

     We have taken steps to improve our UNIX software products to maintain system reliability, maintain backward compatibility, increase application support, provide broad hardware support, better integrate widely used internet applications, improve usability, and increase system performance. While we believe that these product enhancements will extend the lives and improve the functionality of our UNIX products, they will not result in significant revenue increases in the short-term due to the long adoption cycle for new operating system purchases and the length of our operating system product sales cycle as well as the competition in our markets.

     We also deploy engineering resources for our mobility products and services for personal and professional productivity, as well as custom services for business, government and consumer users. We expect these mobility products and services will enable easy, secure, real-time mobile access to all kinds

of information stored in enterprise and web-based systems without the need for direct connection between end-point devices and those systems.

     Our product development process is modeled to standard, commercial software engineering practices and we apply these practices to ensure consistent product quality. As a result, we are able to offer our platform products to OEM customers in several configurations without significant additional effort. We incurred $8,045,000, $8,337,000 and $10,661,000 in research and development expense during the years ended October 31, 2006, 2005 and 2004, respectively.

SCOsource Business

     We acquired our rights relating to the UNIX (including UnixWare) source code and derivative works and other intellectual property rights when we purchased substantially all of the assets and operations of the server and professional services groups of The Santa Cruz Operation, Inc. in May 2001. The Santa Cruz Operation had previously acquired such UNIX source code and other intellectual property rights from Novell in 1995, which technology was initially developed by AT&T Bell Labs. Through this process, we acquired all UNIX source code, source code license agreements with thousands of UNIX vendors, certain UNIX intellectual property, all claims for violation of the above mentioned UNIX licenses and copyrights and other claims, and the control over UNIX derivative works. The UNIX licenses we obtained have led to the development of several UNIX-based operating systems, including but not limited to our own UnixWare and OpenServer products, IBM’s AIX, Sequent’s DYNIX/Ptx, Sun’s Solaris, SGI’s IRIX and Hewlett-Packard’s HP-UX. These operating systems are all derivatives of the original UNIX source code owned by us.

     The success of our SCOsource business depends on our ability to protect and enforce our rights to proprietary UNIX source code, copyrights and other intellectual property rights. To protect our proprietary rights, we rely primarily on a combination of copyright laws, contractual rights and related claims.

     Our intellectual property protection relies primarily on a combination of contract rights, copyright laws and an aggressive legal strategy. We also require that our employees and consultants sign confidentiality and nondisclosure agreements. We also regulate access to, and distribution of, our documentation and other proprietary information.

     We cannot guarantee the success of our SCO Litigation and other efforts to protect and enforce our intellectual property rights, but we will continue to seek to enforce and pursue these rights through the judicial system. Additionally, we cannot be certain that we will succeed in preventing the future misappropriation of our proprietary information including copyrights and other intellectual property rights or that we will be able to prevent the unauthorized future use of our technology.

     As of October 31, 2006, we had a total of 142 full-time equivalent employees. Of the total employees, 40 were in product development, 48 in sales and marketing, 17 in services, 7 in customer delivery and manufacturing, 3 in SCOsource and 27 in administration (which includes finance, human resources, executive management and information systems). From time to time, we also engage independent contractors to support our professional services, product development, sales and marketing organizations. Our employees are not represented by any labor union and are not subject to a collective bargaining agreement, and we have never experienced a work stoppage. In general, we believe our relations with our employees are good.

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

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

     Our year ended October 31, 2003 was the first full year we were profitable in our operating history. Our profitability for the year ended October 31, 2003 resulted primarily from our SCOsource business. For the years ended October 31, 2006, 2005 and 2004, we incurred net losses applicable to common stockholders of $16,598,000, $10,726,000 and $16,227,000, respectively. As of October 31, 2006, our accumulated deficit was $251,540,000.

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

     As of October 31, 2006, we had a total of $7,618,000 in cash and cash equivalents and available-for-sale marketable securities and an additional $5,046,000 of restricted cash to be used to pursue the SCO Litigation. Since October 31, 2004, we have spent a total of $9,954,000 for expert, consulting and other costs and fees as agreed to in the Engagement Agreement with our legal counsel in the SCO Litigation. Our limited cash resources may not be sufficient to fund continuing losses from operations and the expenses of the SCO Litigation.

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

     We continue to pursue the SCO Litigation and believe in the merits of our cases. With respect to our litigation with IBM, both parties are preparing for summary judgment arguments scheduled for March 2007. IBM has filed 6 motions for summary judgment that, if granted in whole or in substantial part, could resolve our claims in IBM’s favor or substantially reduce our claims. We have filed 3 motions for summary judgment.

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

     With respect to our litigation with Novell, Novell claims it did not sell The Santa Cruz Operation, Inc. the UNIX copyrights and it claims it has the right to waive our claims against UNIX source licensees, such as IBM, Novell has filed a motion for preliminary injunction and a motion for partial summary judgment; we have also filed a cross-motion for partial summary judgment. The Court heard arguments on these motions on January 23, 2007, and as of the date of filing of this Form 10-K, no ruling had been made. If Novell prevails on its motion, some or all of our cash and cash equivalents could be encumbered.

     We can not guarantee whether our claims against IBM or Novell will be heard by a jury. The lawsuits with IBM and Novell will continue to be costly. In the event we are not successful with the IBM

or Novell motions, or the continuing litigation requires more cash than expected, our business and operations would be materially harmed.

     If we do not prevail in our action against IBM, or if IBM is successful in its counterclaims against us, our business and results of operations would be materially harmed. Additionally, the market price of our common stock may be negatively affected as a result of developments in our legal action against IBM that may be, or maybe perceived to be, adverse to us.

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

Our claims relating to our UNIX intellectual property may subject us to additional legal proceedings.

     In August 2003, Red Hat brought a lawsuit against us asserting that the Linux operating system does not infringe our UNIX intellectual property rights and seeking a declaratory judgment for non-infringement of copyrights and no misappropriation of trade secrets. In addition, Red Hat claims we have engaged in false advertising in violation of the Lanham Act, deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, and trade libel and disparagement. Although this case is currently stayed pending the resolution of our suit against IBM, we intend to vigorously defend this action. However, if Red Hat is successful in its claim against us, our business and results of operations could be materially harmed.

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

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

     On June 5, 2006, we entered into an amendment to the Engagement Agreement and agreed with the Law Firms to deposit an additional $5,000,000 into the escrow account to cover additional expert, consulting and other expenses. During October 2006, we deposited an additional $5,000,000 into the escrow account. In the event that we exhaust these funds, we must continue to pay for expert, consulting and other expenses through the conclusion of our litigation with IBM. As we continue with discovery and other trial preparations, we may be required to place additional amounts into the escrow account, which could further reduce our liquidity position. As of October 31, 2006, we had a total of $7,618,000 in cash and cash equivalents and available-for-sale marketable securities and an additional $5,046,000 of restricted cash to be used to pursue the SCO Litigation. Since October 31, 2004, we have spent a total of $9,954,000 for expert, consulting and other costs and fees as agreed to in the Engagement Agreement with our legal counsel in the SCO Litigation.

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

     Developments in the SCO Litigation and fluctuations in our operating results or our failure to meet the expectations of analysts or investors, even in the short-term, could cause our stock price to decline significantly. Because of the potential for fluctuations in our expenses related to the SCO Litigation in any particular period, you should not rely on comparisons of our results of operations as an indication of future performance.

     Factors that may affect our results include:

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

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

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

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

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

     The success of our UNIX business will depend on the level of commitment and certification we receive from industry partners and developers. In recent years, we have seen hardware and software vendors as well as software developers turn their certification and application development efforts toward Linux and elect not to continue to support or certify to our UNIX operating system products. If

this trend continues, our competitive position will be adversely impacted and our future revenue from our UNIX business will decline. The decline in our UNIX business may be accelerated if industry partners withdraw their support from us for any reason, including our SCO Litigation.

If the market for UNIX continues to contract, our business will be harmed.

     Our revenue from the sale of UNIX products has declined over the last several years. This decrease in revenue has been attributable primarily to increased competition from other operating systems, particularly Linux. Our sales of UNIX products and services are primarily to existing customers. If the demand for UNIX products continues to decline, and we are unable to develop UNIX products and services that successfully address a market demand, our UNIX revenue will continue to decline, industry participants may not certify to our operating system and products, we may not be able to attract new customers or retain existing customers and our business and results of operations will be adversely affected. Because of the long adoption cycle for operating system purchases and the long sales cycle of our operating system products, we may not be able to reverse these revenue declines quickly.

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

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

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

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

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

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

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

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

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

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

We could lose our listing on the Nasdaq Capital Market if our stock price falls below $1.00 for 30 consecutive business days, and the loss of the listing would make our stock significantly less liquid and would affect its value.

     Our common stock is listed on the Nasdaq Capital Market and had a closing price of $1.04 at the close of the market on January 24, 2007. If the price of our common stock falls below $1.00 and for 30 consecutive business days remains below $1.00, we will receive a deficiency notice from NASDAQ advising us that we have been afforded a 180-calendar day compliance period. If our stock fails to maintain a minimum bid price of $1.00 for 10 consecutive business days during a 180-day compliance period on the Nasdaq Capital Market or a 360-day grace period if compliance with certain core listing standards are demonstrated, we could receive a delisting notice from the Nasdaq Capital Market, and, under certain circumstances, even if our stock maintains a minimum bid price of $1.00 for 10 consecutive business days, we may receive a delisting notice from the Nasdaq Capital Market. Upon delisting from the Nasdaq Capital Market, our stock would be traded over-the-counter, more commonly known as OTC. OTC transactions involve risks in addition to those associated with transactions in securities traded on the Nasdaq Capital Market. Many OTC stocks trade less frequently and in smaller volumes than securities traded on the Nasdaq Capital Market. Accordingly, our stock would be less liquid than it would otherwise be, and the value of our stock could decrease.

Our stock price is volatile.

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

     As of December 31, 2006, we have issued outstanding options to purchase up to approximately 5,499,000 shares of common stock with an average exercise price of $3.83 per share. The existence of such rights to acquire common stock at fixed prices may prove a hindrance to our efforts to raise future equity and debt funding, and the exercise of such rights will dilute the percentage ownership interest of our stockholders and may dilute the value of their ownership. The possible future sale of shares issuable on the exercise of outstanding options could adversely affect the prevailing market price for our common stock. Further, the holders of the outstanding stock options may exercise them at a time when we would otherwise be able to obtain additional equity capital on terms more favorable to us.

Common stock available for resale may depress the market price of our common stock.

     We have filed a post-effective amendment to a registration statement with the Securities and Exchange Commission (“SEC”), which has been declared effective, covering the potential resale by two of our stockholders of up to 923,019 shares of common stock, or 4.3% of our outstanding common stock. The selling stockholders are bound by certain selling limitations, which limit the numbers of shares of our common stock that may be sold at one time. In addition, we have filed a registration statement with the SEC, which has been declared effective, covering the potential resale by some of our stockholders of up to 2,852,449 shares of our common stock, or 13.4% of our outstanding common stock. The existence of a substantial number of shares of common stock subject to immediate resale could depress the market price for our common stock and impair our ability to raise needed capital.

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

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

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

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

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

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

     Not applicable.

     We are headquartered in Lindon, Utah, where we lease administrative, sales and marketing facilities. We lease additional facilities for administration, sales and marketing and product development in Scotts Valley, California and Murray Hill, New Jersey. The leases for our facilities expire at various dates through our fiscal year ending October 31, 2008.

     Our international field operations occupy leased facilities in France, Japan, Germany, India, and the United Kingdom. The leases for these field operation facilities expire at various dates through our fiscal year ending October 31, 2008.

     As indicated in Item 1, we have two business segments: UNIX and SCOsource. These segments use substantially all of the properties, at least in part, and we retain the flexibility to use each of our properties in whole or in part for each of our segments.

     We believe that our existing facilities are adequate to meet current business and operating requirements and that additional office space will be available to meet our needs if required.

IBM Corporation

     On or about March 6, 2003, we filed a civil complaint against IBM. The case is pending in the United States District Court for the District of Utah, under the title The SCO Group, Inc. v. International Business Machines Corporation, Civil No. 2:03CV0294. In this action we claim that IBM breached its UNIX source code licenses (both the IBM and Sequent Computer Systems, Inc. “Sequent” licenses) by disclosing restricted information concerning the UNIX source code and derivative works and related information in connection with its efforts to promote the Linux operating system. Our complaint includes, among other things, claims for breach of contract, unfair competition, tortious interference and copyright infringement. We are seeking damages in an amount to be proven at trial and seeking injunctive relief.

     On or about March 6, 2003, we notified IBM that IBM was not in compliance with our UNIX source code license agreement and on or about June 13, 2003, we delivered to IBM a notice of termination of that agreement, which underlies IBM’s AIX software. On or about August 11, 2003, we sent a similar notice terminating the Sequent source code license. IBM disputes our right to terminate those licenses. In the event our termination of those licenses is valid we believe IBM is exposed to substantial damages and injunctive relief based on its continued use and distribution of the AIX operating system. On June 9, 2003, Novell sent us a notice purporting to waive our claims against IBM regarding its license breaches. We do not believe that Novell had the right to take any such action relative to our UNIX source code rights.

     On February 27, 2004, we filed a second amended complaint which alleges 9 causes of action that are similar to those set forth above, adds a new claim for copyright infringement, and removes the claim for misappropriation of trade secrets. IBM filed an answer and 14 counterclaims. Among other things, IBM has asserted that we do not have the right to terminate IBM’s UNIX license and IBM has claimed that we have breached the GNU General Public License and have infringed certain patents held by IBM. IBM’s counterclaims include claims for breach of contract, violation of the Lanham Act, unfair competition, intentional interference with prospective economic relations, unfair and deceptive trade practices, promissory estoppel, patent infringement and a declaratory judgment claim for non-infringement of copyrights. On October 6, 2005, IBM voluntarily dismissed with prejudice its claims for patent infringement.

     On December 22, 2005, we filed a voluminous report detailing IBM’s misuse of our proprietary material. Our December 2005 report includes 293 total disclosures which we claim violate our contractual rights and copyrights. These reports and the disclosures identified are the result of analysis from experienced outside technical consultants.

     On February 13, 2006, IBM filed a motion with the court seeking to limit our claims as set forth in the December 2005 report. IBM argued that of the 293 items we had identified, 201 did not meet the level of specificity required by the court. IBM requested that we be limited to 93 items set forth in the December 2005 filing which IBM claims meet the required level of specificity. On June 28, 2006, the Magistrate Judge issued a ruling striking over 180 of our technology disclosures from the case. This ruling is a limitation of the number of technology disclosures we challenged in our December 2005 filing, but means that over 100 of the challenged items remain in the case. On July 13, 2006, we filed objections to the Magistrate Judge’s order with the District Court; those objections challenge the process and the result embodied in the Magistrate Judge’s order. On November 29, 2006, the District Court issued a ruling sustaining in full the Magistrate Judge’s ruling of June 28, 2006.

     On June 8, 2006, IBM filed a motion to confine our claims to, and strike allegations in excess of, the final disclosures. In this motion, IBM claims that our technology expert reports go beyond the disclosures contained in our December 2005 submission to the Court and that those expert reports should be restricted to that extent. On December 21, 2006, the Magistrate Judge granted IBM’s motion. We have filed objections to that order with the District Court.

     Both parties have filed expert reports and substantially finished expert discovery. IBM has filed 6 motions for summary judgment that, if granted in whole or in substantial part, could resolve our claims in IBM’s favor or substantially reduce our claims. We have filed 3 motions for summary judgment. The summary judgment motions are set to be heard by the Court in March 2007 and a trial date has been postponed until sometime after September 2007.

Novell, Inc.

     On January 20, 2004, we filed suit in Utah state court against Novell, Inc. for slander of title seeking relief for its alleged bad faith effort to interfere with our ownership of copyrights related to our UNIX source code and derivative works and our UnixWare product. The case is pending in the United States District Court for the District of Utah under the caption, The SCO Group, Inc. v. Novell, Inc., Civil No. 2:04CV00139. In the lawsuit, we requested preliminary and permanent injunctive relief as well as damages. Through these claims, we seek to require Novell to assign to us all copyrights that we believe Novell has wrongfully registered, to prevent Novell from claiming any ownership interest in those copyrights, and to require Novell to retract or withdraw all representations it has made regarding its purported ownership of those copyrights and UNIX itself.

     Novell filed two motions to dismiss claiming, among other things, that Novell’s false statements were not uttered with malice and are privileged under the law. The court denied both of Novell’s motions to dismiss. On July 29, 2005, Novell filed its answer and counterclaims against us, asserting counterclaims for our alleged breaches of the Asset Purchase Agreement between Novell and our predecessor-in-interest, The Santa Cruz Operation, for slander of title, restitution/unjust enrichment, an accounting related to Novell’s retained binary royalty stream, and for declaratory relief regarding Novell’s alleged rights under the Asset Purchase Agreement. On or about December 30, 2005, we filed a motion for leave to amend our complaint to assert additional claims against Novell including copyright infringement, unfair competition and a breach of Novell’s limited license to use our UNIX code. Novell consented to our filing of these additional claims.

     On or about April 10, 2006, Novell filed a motion to stay the case in Utah pending a request for arbitration that Novell and SuSE Linux, GmbH (“SuSE”) filed on the same date in the International Court of Arbitration in France. Through these proceedings, Novell claims that we granted SuSE the right to use

our intellectual property through our participation in the UnitedLinux initiative in 2002 and through its acquisition of SuSE, Novell acquired SuSE’s rights as a member of UnitedLinux. On August 21, 2006, the District Court ordered that portions of claims relating to the SuSE arbitration should be stayed but the other portions of claims in the case should proceed. Trial for the remaining matters has been set for September 2007.

     The three-person arbitration panel has been selected for the SuSE arbitration in Switzerland, and that process has commenced. The arbitration has been set for December 2007. The proceedings in early 2007 will determine the scope of the arbitration.

     In September 2006, Novell filed an Amended Counterclaim asserting 9 claims for relief including, among other things, claims for slander of title, breach of contract, declaratory relief and claims for an accounting, and for a constructive trust over certain revenue we collected from Sun and Microsoft in 2003. Novell has moved for a preliminary injunction and partial summary judgment. We have opposed these filings and filed a cross-motion for partial summary judgment. Those motions were argued on January 23, 2007, before the District Court and as of the date of filing of this Form 10-K, no ruling had been made. If Novell prevails on these motions, some or all of our cash and cash equivalents could be encumbered.

IPO Class Action Matter

     We are an issuer defendant in a series of class action lawsuits involving over 300 issuers that have been consolidated under In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). The consolidated complaint alleges, among other things, certain improprieties regarding the underwriters’ conduct during our initial public offering and the failure to disclose such conduct in the registration statement in violation of the Securities Act of 1933, as amended. Class standing was certified for all of these cases by the district court.

     The plaintiffs, the issuers and the insurance companies negotiated and executed an agreement to settle the dispute between the plaintiffs and the issuers. While the settlement agreement was awaiting approval by the district court, the court of appeals overturned the class certification on December 5, 2006. It is unlikely a settlement of a class action can remain effective as the class is de-certified. If the decision by the court of appeals is not reversed, we do not believe the settlement will stand, and it is possible the lawsuit may fragment into individual actions. At this time, we do not know and cannot determine the legal or procedural results of such an action. If the de-certification is reversed, and if thereafter the settlement agreement is approved by the court, and if no cross-claims, counterclaims or third-party claims are later asserted, this action will be dismissed with respect to us and our directors. If the settlement agreement is not approved by the court, the matter will continue unless another settlement agreement is reached.

     We have notified our underwriters and insurance companies of the existence of the claims. Management presently believes, after consultation with legal counsel, that the ultimate outcome of this matter will not have a material adverse effect on our results of operations or financial position and will not exceed the $200,000 self-insured retention already paid or accrued by us.

Red Hat, Inc.

     On August 4, 2003, Red Hat, Inc. filed a complaint against us. The action is pending in the United States District Court for the District of Delaware under the case caption, Red Hat, Inc. v. The SCO Group, Inc., Civil No. 03-772. Red Hat asserts that the Linux operating system does not infringe on our UNIX intellectual property rights and seeks a declaratory judgment for non-infringement of copyrights and no misappropriation of trade secrets. In addition, Red Hat claims we have engaged in false advertising in violation of the Lanham Act, deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, trade libel and disparagement. On April 6, 2004,

the court denied our motion to dismiss this case; however, the court stayed the case and requested status reports every 90 days regarding the case against IBM. Red Hat filed a motion for reconsideration, which the court denied on March 31, 2005. We intend to vigorously defend this action. In the event the stay is lifted and Red Hat is allowed to pursue its claims, we will likely assert counterclaims against Red Hat.

Other Matters

     In April 2003, a former Indian distributor filed a claim in India, requesting summary judgment for payment of approximately $1,428,000, and an order that we trade in India only through the distributor and/or give a security deposit until the claim is paid. The distributor claims that we are responsible to repurchase certain software products and to reimburse the distributor for certain other operating costs. Management does not believe that we are responsible to reimburse the distributor for any operating costs and also believes that the return rights related to any remaining inventory have lapsed. The distributor additionally requested that the Indian courts grant interim relief in the form of attachment of local assets. These requests for interim relief have failed in the court, and discovery has commenced and hearings on the main claims have been held and are ongoing. We intend to vigorously defend this action.

     Pursuit and defense of the above-mentioned matters will be costly, and management expects the costs for legal fees and related expenses will be substantial.

     We are party to certain other legal proceedings arising in the ordinary course of business. Management believes, after consultation with legal counsel, that the ultimate outcome of these legal proceedings will not have a material adverse effect on our results of operation, financial position or liquidity.

     There were no matters submitted to a vote of security holders during the three months ended October 31, 2006.

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Price of Our Common Stock

     Our common stock initially traded on The Nasdaq National Market beginning in March 2000, but has been traded on The Nasdaq Capital Market (formerly known as the Nasdaq SmallCap Market) since February 2003. In September 2002, we changed our trading symbol from “CALD” to “SCOX.” The table below sets forth the range of high and low closing prices of our common stock as reported on the Nasdaq Capital Market, as applicable, for the last two years.

     On January 24, 2007, the closing sales price for our common stock as reported by The Nasdaq Capital Market was $1.04. As of January 19, 2007, there were 386 holders of common stock of record.

Dividend Policy

     We have not historically declared or paid any cash dividends on shares of our common stock and plan to retain our future earnings, if any, to fund the development and growth of our business.

Issuer Purchases of Equity Securities

     During the three months ended October 31, 2006, we did not purchase any of our equity securities.

     The following selected financial data set forth below should be read in conjunction with the consolidated financial statements and the related notes included elsewhere in this Form 10-K and in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in Part II, Item 7 of this Form 10-K. The selected statement of operations data for the years ended October 31, 2006, 2005 and 2004 and the selected balance sheet data as of October 31, 2006 and 2005 are derived from, and are qualified by reference to, the audited consolidated financial statements and related notes in this Form 10-K.

     The selected statement of operations data for the years ended October 31, 2003 and 2002 and the selected balance sheet data as of October 31, 2004, 2003 and 2002 are derived from audited consolidated financial statements not appearing in this Form 10-K.

     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” under Part I, Item 1A 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, 2006. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law.

Business Focus

     UNIX Business. Our UNIX business serves the needs of small-to-medium sized businesses, including replicated site franchisees of Fortune 1000 companies, by providing reliable, cost effective UNIX software technology for distributed, embedded and network-based systems. Our largest source of UNIX business revenue is derived from existing customers through our worldwide, indirect, leveraged channel of partners, which includes distributors and independent solution providers. We have a presence in a number of countries that provide support and services to customers and resellers. The other principal channel for selling and marketing our UNIX products is through existing customers that have a large number of replicated sites or franchisees.

     We access these corporations through their information technology or purchasing departments with our Area Sales Managers (“ASMs”) in the United States and through our reseller channel in countries outside the United States. In addition, we also sell our operating system products to original equipment manufacturers (“OEMs”). Our sales of UNIX products and services during the last several years have been primarily to existing UNIX customers and not newly acquired customers. Our UNIX business revenue depends significantly on our ability to market and sell our products to existing customers and to generate upgrades from existing customers.

     The following table and footnote shows the operating results of the UNIX business for the years ended October 31, 2006, 2005 and 2004:

     Revenue from our UNIX business decreased by $6,715,000, or 19%, for the year ended October 31, 2006 compared to the year ended October 31, 2005, and decreased by $6,142,000, or 15%, for the year ended October 31, 2005 compared to the year ended October 31, 2004. The revenue from our UNIX business has been declining over the last several years primarily as a result of continued competition from alternative operating systems, particularly Linux. We believe that the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX business revenue because users of Linux generally do not pay for the operating system itself, but for services and maintenance.

     Operating costs for our UNIX business decreased from $42,325,000 for the year ended October 31, 2004 to $28,604,000 for the year ended October 31, 2005, and were $28,754,000 for the year ended October 31, 2006. The cost reductions from the year ended October 31, 2005 compared to the year ended October 31, 2004 were primarily attributable to reduced headcount and consolidation of certain facilities. The slight reduction in costs for the year ended October 31, 2006 compared to the year ended October 31, 2005 was primarily attributable to lower personnel and related costs offset by stock-based compensation.

     The decline in our UNIX business revenue may be accelerated if industry partners withdraw their support as a result of our SCO Litigation. The decline in our UNIX business and the SCO Litigation may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products. This would lead to an accelerated decline in revenue from our UNIX business.

     SCOsource Business. During the year ended October 31, 2003, we became aware that our UNIX code and derivative works had been inappropriately included by others in the Linux operating system. We believe the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX business because users of Linux generally do not pay for the operating system itself, but pay for services and maintenance. The Linux operating system competes directly with our OpenServer and UnixWare products and has taken significant market share from these products.

     In an effort to protect and defend our UNIX intellectual property, we initiated our SCOsource business. We have incurred significant legal costs in an effort to defend and protect our UNIX intellectual property and expect that costs and expenses for this business for the year ending October 31, 2007 will be material.

     The following table shows the results of operations for the SCOsource business for the years ended October 31, 2006, 2005 and 2004:

     Revenue from our SCOsource business decreased from $829,000 for the year ended October 31, 2004 to $166,000 for the year ended October 31, 2005, and decreased to $116,000 for the year ended October 31, 2006. Revenue for the years ended October 31, 2006, 2005 and 2004 was primarily attributable to sales of our SCOsource IP agreements.

     Cost of revenue from the SCOsource business was $19,743,000 for the year ended October 31, 2004, $12,847,000 for the year ended October 31, 2005 and $12,307,000 for the year ended October 31, 2006. Cost of revenue was primarily attributable to legal fees and other costs and expenses incurred in connection with the SCO Litigation. During the year ended October 31, 2006, we made the final payment to the law firms of Boies, Schiller & Flexner LLP, Berger Singerman, and Kevin McBride (the “Law Firms”) for legal fees, but are continuing to pay for the costs of experts, consultants and other costs of the SCO Litigation. In addition to the expenses incurred above, we must also pay one or more contingency fees upon any amount we or our stockholders may receive as a result of a settlement, judgment, or a sale of our company.

     The decrease in operating expenses was primarily attributable to decreased personnel and related costs.

     Because of the uncertainties related to our SCOsource business, the success of the SCOsource business depends on the strength of our intellectual property rights and claims regarding UNIX, including our claims against Novell and the strength of our claim that unauthorized UNIX source code and derivative works are contained in Linux.

Critical Accounting Estimates

     The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles 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 2 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 estimates because they are important to the portrayal of our financial condition and results and they are based on matters that are inherently uncertain.

     Our critical accounting policies and estimates include the following:

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

     We recognize product revenue upon shipment if a signed contract exists, the fee is fixed or determinable, collection of the resulting receivable is probable and product returns are reasonably estimable.

     The majority of our revenue transactions relate to product-only sales. On occasion, we have revenue transactions that have multiple elements (such as software products, maintenance, technical support services, and other services). For software agreements that have multiple elements, we allocate revenue to each component of the contract based on the relative fair value of the elements. The fair value

of each element is based on vendor specific objective evidence (”VSOE”). VSOE is established when such elements are sold separately. We recognize revenue when the criteria for product revenue recognition set forth above have been met. If VSOE of all undelivered elements exists, but VSOE does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the license fee is recognized as revenue in the period when persuasive evidence of an arrangement is obtained assuming all other revenue recognition criteria are met.

     We recognize product revenue from OEMs when the software is sold by the OEM to an end-user customer. Revenue from technical support services and consulting services is recognized as the related services are performed. Revenue for maintenance is recognized ratably over the maintenance period.

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

     Our SCOsource revenue to date has been primarily generated from agreements to utilize our UNIX source code as well as from intellectual property compliance agreements. We recognize revenue from SCOsource agreements when a signed contract exists, the fee is fixed or determinable, collection of the receivable is probable and delivery has occurred. If the payment terms extend beyond our normal payment terms, revenue is recognized as the payments become due.

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

     Litigation Reserves. We are party to a number of legal matters described in more detail elsewhere in this annual report on Form 10-K. Pursuit and defense of these matters will be costly, and management expects the costs for legal fees and related expenses will be substantial. A material, negative impact on our results of operations or financial position from the Red Hat, Inc., IPO Class Action, or Indian Distributor matters, or the IBM and Novell counterclaims is neither probable nor estimable. Because these matters are not probable or estimable, we have not recorded any reserves or contingencies related to these legal matters. In the event that our assumptions used to evaluate these matters as neither probable nor estimable changes in future periods, we may be required to record a liability for an adverse outcome, which could have a material adverse effect on our results of operations, financial position and liquidity.

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

     Write-downs of long-lived assets may be necessary if the future fair value of these assets is less than the carrying value. If the operating trends for our UNIX or SCOsource businesses continue to

decline, we may be required to record an impairment charge in a future period related to the carrying value of our long-lived assets.

     Allowance for Doubtful Accounts Receivable. We offer credit terms on the sale of our products to a majority of our customers and require no collateral from these customers. We perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts based upon our historical collection experience and a specific review of customer balances to determine expected collectibility. Our policies for determining allowances for doubtful accounts have been applied consistently. Our allowance for doubtful accounts receivable was $106,000 as of October 31, 2006. We have not experienced material differences from the actual amounts provided for bad debts and our recorded estimates. However, our actual bad debts in future periods may differ from our current estimates and the differences may be material, which may have an adverse impact on our future accounts receivable and cash position.

Results of Operations

     The following table presents our consolidated results of operations for the years ended October 31, 2006, 2005 and 2004:

Revenue

     Revenue for the year ended October 31, 2006 decreased by $6,765,000, or 19%, from the year ended October 31, 2005 and revenue for the year ended October 31, 2005 decreased by $6,805,000, or 16%, from the year ended October 31, 2004. These decreases were primarily attributable to a decrease in UNIX products and services revenue as a result of continued competition from other operating systems, primarily Linux.

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

     The decrease in revenue in the UNIX business of $6,715,000 for the year ended October 31, 2006 compared to the year ended October 31, 2005 and the decrease in revenue of $6,142,000 for the year ended October 31, 2005 compared to the year ended October 31, 2004 was primarily attributable to continued competition from other operating systems, particularly Linux. We believe that the inclusion of our UNIX code and derivative works in Linux has been a contributor to the decline in our UNIX revenue because users of Linux generally do not pay for the operating system itself, but pay for services and maintenance. We anticipate that for the year ending October 31, 2007 our total UNIX revenue will decline from UNIX revenue generated in the year ended October 31, 2006 as a result of this continued competition.

     SCOsource revenue decreased by $50,000 for the year ended October 31, 2006 compared to the year ended October 31, 2005 and decreased by $663,000 for the year ended October 31, 2005 compared to the year ended October 31, 2004. This decrease was primarily attributable to lower sales of IP agreements.

     Sales of our UNIX products and services during the years ended October 31, 2006, 2005 and 2004 were primarily to existing customers. Our UNIX business revenue depends significantly on our ability to market our products to existing customers and to generate upgrades from existing customers. Our UNIX revenue may be lower than currently anticipated if (1) we are not successful with our existing customers, (2) we lose the support of any of our existing hardware and software vendors, or (3) our key industry partners withdraw their marketing and certification support or direct their support to our competitors.

Products Revenue

     Our products revenue consists of software licenses for UNIX products such as OpenServer and UnixWare, as well as sales of UNIX-related products. Products revenue also includes revenue derived from OEMs, distribution partners and large end-user accounts. We rely heavily on our two-tier

distribution channel and any disruption in our distribution channel could have an adverse impact on future revenue.

     The decrease in products revenue of $6,127,000 from the year ended October 31, 2005 to the year ended October 31, 2006 and the decrease of $5,162,000 from the year ended October 31, 2004 to the year ended October 31, 2005 was primarily attributable to decreased sales of OpenServer and UnixWare products. These decreases primarily resulted from continued competition in the operating system market, particularly Linux. We believe that this competition from Linux will continue for the year ending October 31, 2007 and 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 products was as follows:

     The decreases in revenue for OpenServer and UnixWare and other products are all primarily the result of continued competition, particularly from Linux operating system providers. The decrease in other products revenue is primarily attributable to decreased sales of UNIX-related products and decreased sales of product maintenance, which is sold separately from the product.

SCOsource Licensing Revenue

     We initiated our SCOsource business for the purpose of protecting and defending our intellectual property rights in our UNIX source code and derivative works. SCOsource licensing revenue was $116,000 for the year ended October 31, 2006, $166,000 for the year ended October 31, 2005 and $829,000 for the year ended October 31, 2004. The SCOsource revenue for the years ended October 31, 2006, 2005 and 2004 was primarily attributable to SCOsource IP agreements. We believe and assert that our minimal SCOsource revenue for the years ended October 31, 2006, 2005 and 2004 was, in part, attributable to Novell’s claim of UNIX copyright ownership, which may have caused potential customers to delay or forego licensing until an outcome in this legal matter has been reached.

     We are unable to predict the amount and timing of future SCOsource licensing revenue.

Services Revenue

     Services revenue consists primarily of annual and incident technical support fees, engineering services fees, professional services and consulting fees. These fees are typically charged and invoiced

separately from UNIX products sales. The decrease in services revenue of $588,000, or 10%, from the year ended October 31, 2005 to the year ended October 31, 2006 and the decrease of $980,000, or 15%, from the year ended October 31, 2004 to the year ended October 31, 2005 was primarily attributable to a decrease in products revenue, decreased professional services revenue and fewer renewals of support and engineering services contracts.

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

Cost of Products Revenue

     Cost of products revenue consists of manufacturing costs, royalties to third-party vendors, technology costs and overhead costs. Cost of products revenue decreased by $480,000, or 19%, from the year ended October 31, 2005 to the year ended October 31, 2006 and decreased by $677,000, or 21%, from the year ended October 31, 2004 to the year ended October 31, 2005. This decrease in cost of products revenue was primarily attributable to lower products revenue, as margins did not vary significantly.

     For the year ending October 31, 2007, we expect the dollar amount of our cost of products revenue to be less than the year ended October 31, 2006 and, as a percentage of products revenue, to be consistent with the percentage achieved during the year ended October 31, 2006.

Cost of SCOsource Licensing Revenue

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

     Cost of SCOsource licensing revenue decreased by $540,000, or 4%, from the year ended October 31, 2005 to the year ended October 31, 2006 and was primarily attributable to decreased legal fees paid to the Law Firms offset, in part, by increases in costs and expenses for experts, consultants and other costs of the SCO Litigation. Cost of SCOsource licensing revenue decreased by $6,896,000, or 35%, from the year ended October 31, 2004 to the year ended October 31, 2005 and was primarily attributable to decreased fees paid to the Law Firms as a result of an amendment to cap the total future legal fees to be paid to the Law Firms. In addition to the expenses discussed above, we must also pay one or more contingency fees upon any amount we or our stockholders may receive as a result of a settlement, judgment, or a sale of our company.

     We anticipate that the dollar amount of our cost of SCOsource licensing revenue for the year ending October 31, 2007 will be lower than the year ended October 31, 2006. However, future legal fees may include contingency payments made to the Law Firms as a result of a settlement, judgment, or a sale of our company, which could cause the cost of SCOsource licensing revenue for the year ending October 31, 2007 to be higher than the year ended October 31, 2006.

     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 $90,000, or 3%, from the year ended October 31, 2005 to the year ended October 31, 2006 and decreased by $1,212,000, or 29%, from the year ended October 31, 2004 to the year ended October 31, 2005 and was primarily attributable to reduced employee and employee-related costs.

     For the year ending October 31, 2007, we expect the dollar amount of our cost of services revenue to be less than that incurred for the year ended October 31, 2006 and that cost of services revenue as a percentage of services revenue will be lower than that generated for the year ended October 31, 2006.

Sales and Marketing

     Sales and marketing expenses consist of the salaries, commissions and other personnel costs of employees involved in the revenue generation process, as well as advertising and corporate allocations. The increase in sales and marketing expense of $215,000, or 2%, from the year ended October 31, 2006 compared to the year ended October 31, 2005 was primarily attributable to an increase in spending related to the release and marketing of our mobile services product offerings and from stock-based compensation. The decrease of $5,279,000, or 31%, from the year ended October 31, 2004 to the year ended October 31, 2005 was primarily attributable to reductions in sales and marketing employees, reduced travel expenses, less commissions and lower advertising costs. Included in sales and marketing expenses for the years ended October 31, 2006, 2005 and 2004, was $371,000, $14,000 and $75,000, respectively, for stock-based compensation.

     For the year ending October 31, 2007, we anticipate that the dollar amount of sales and marketing expense will decrease from the year ended October 31, 2006.

Research and Development

     Research and development expenses consist of the salaries and benefits of software engineers, consulting expenses and corporate allocations. Research and development expenses decreased by $292,000, or 4%, from the year ended October 31, 2005 to the year ended October 31, 2006 and this decrease was primarily attributable to decreased personnel and personnel-related costs offset, in part, by an increase in stock-based compensation. Research and development expenses decreased by $2,324,000, or 22%, from the year ended October 31, 2004 to the year ended October 31, 2005 and this decrease was primarily attributable to decreased personnel and personnel-related costs. During the years ended October 31, 2005 and 2004, our engineering efforts were primarily focused on the release of UnixWare 7.1.4 and on the release of OpenServer 6; both significant releases of our two primary operating system products. These development efforts required us to maintain our research and development

infrastructure, which limited our ability to cut costs in this area as significantly as we have done in other areas. Included in research and development expenses for the years ended October 31, 2006, 2005 and 2004, was $140,000, $8,000 and $49,000, respectively, for stock-based compensation.

     For the year ending October 31, 2007, we anticipate that the dollar amount of research and development expenses will decrease from the year ended October 31, 2006.

General and Administrative

     General and administrative expenses consist of the salaries and benefits of finance, human resources, and executive management and expenses for professional services such as legal and accounting services and corporate allocations. General and administrative expenses decreased by $119,000, or 2%, from the year ended October 31, 2005 to the year ended October 31, 2006 and this decrease was primarily attributable to decreased personnel and personnel-related costs as well as from decreased accounting and legal fees, offset, in part, by an increase in stock-based compensation. General and administrative expenses decreased by $1,374,000, or 16%, from the year ended October 31, 2004 to the year ended October 31, 2005 and this decrease was primarily attributable to lower personnel and related costs offset, in part, by increased legal and accounting costs related to the restatement of our quarterly financial statements in April 2005. Included in general and administrative expenses for the years ended October 31, 2006, 2005, and 2004, was $974,000, $0, and $795,000, respectively, for stock-based compensation.

     For the year ending October 31, 2007, we anticipate that the dollar amount of general and administrative expenses will decrease from the year ended October 31, 2006.

     During the years ended October 31, 2006, 2005 and 2004, we recorded $2,371,000, $2,372,000 and $2,566,000, respectively, for the amortization of intangible assets with finite lives. The decrease of $194,000, or 8%, from the year ended October 31, 2005 compared to the year ended October 31, 2004 was primarily attributable to reduced amortization expense recorded on certain assets acquired from Vultus in June 2003 that were written off during the year ended October 31, 2004. As of October 31, 2006, all intangible assets had been fully amortized.

Equity in Income of Affiliate

     We account for our ownership interests in companies in which we own at least 20% and less than 50% using the equity method of accounting. Under the equity method, we record our portion of the entities’ net income or net loss in our consolidated statements of operations. As of October 31, 2006, the carrying value of our investment of $389,000 was for our 30% ownership in a Chinese company.

     During the years ended October 31, 2006, 2005 and 2004, we recorded $91,000, $47,000 and $111,000, respectively, representing our portion of the net income in this entity.

     Other income, net, consisted of the following components for the years ended October 31, 2006, 2005 and 2004:

     Interest income increased by $343,000 for the year ended October 31, 2006 from the year ended October 31, 2005 and was primarily attributable to higher cash and available-for-sale securities balances and higher rates earned on these balances. Interest income decreased by $528,000 from the year ended October 31, 2004 to the year ended October 31, 2005 and was primarily attributable to the decrease in our cash and available-for-sale securities balances.

     The income recorded on the change in fair value of derivative for the years ended October 31, 2004 related to the decrease in fair value of this instrument and marking it to market at each balance sheet date. The derivative financial instrument was settled during the three months ended April 30, 2004.

     The increase in other income, net, from the year ended October 31, 2004 to the year ended October 31, 2005, as well as the decrease from the year ended October 31, 2005 as compared to the year ended October 31, 2006 was primarily attributable to two items: 1) the collection of a note receivable from Vintela, Inc. (“Vintela”) as described in more detail in Note 10 to our financial statements, which note receivable was originally received in April 2003, but because we received the note receivable in exchange for the transfer of certain software to a related party and there was substantial doubt concerning the ability of Vintela to repay the note, no gain was recognized until the three months ended January 31, 2005 when we received payment; and 2) the sale of shares we held in Troll Tech AS (“Troll Tech”) as described in more detail in Note 4 to our financial statements. The Troll Tech shares had been written off in the year ended October 31, 2001, but because they were sold during the year ended October 31, 2005, we recorded income for the proceeds received.

Provision for Income Taxes

     The provision for income taxes for the years ended October 31, 2006, 2005 and 2004 was $91,000, $273,000 and $1,395,000, respectively. The decrease in the provision for income taxes for the year ended October 31, 2006 compared to the year ended October 31, 2005 was primarily attributable to the receipt of a tax refund by our subsidiary. The decrease in the provision for income taxes of $1,122,000 from the year ended October 31, 2004 to the year ended October 31, 2005 was primarily attributable to an accrual for withholding taxes of approximately $710,000 made in the year ended October 31, 2004 in connection with our operations in India. Other than the accrual previously mentioned, our provision for income taxes is primarily related to earnings in foreign subsidiaries as well as from withholding taxes on revenue generated in certain foreign locations.

     As of October 31, 2006, we had net operating loss carry-forwards for U.S. federal and state income tax reporting purposes of approximately $162,112,000 that expire at various dates between 2020 and 2026. The Internal Revenue Code contains provisions under Section 382 which limit our ability to utilize net operating losses in the event that we have experienced a more than 50% change in ownership over a 3-year period. Current estimates prepared by us indicate that due to ownership changes which have occurred, approximately $130,736,000 of the net operating losses are currently subject to an annual limitation of $3,041,000, but may be further limited by additional ownership changes which may occur in

the future. As stated above, the net operating loss carry-forwards expire between 2020 and 2026, allowing us to utilize approximately $60,820,000 of the limited net operating loss carry-forwards over a 20-year period. The balance of the net operating loss carry-forwards of approximately $31,376,000 is not currently subject to a limitation, but if ownership changes occur in the future, this amount may be subject to additional limitations under Section 382.

     We had net deferred income tax assets, including net operating loss carry-forwards and other temporary differences between book and tax deductions, totaling approximately $76,385,000 as of October 31, 2006. A valuation allowance in the amount of $76,385,000 has been recorded as of October 31, 2006 as a result of uncertainties regarding the ultimate realizability of any of the net deferred income tax assets.

     In October 2003, we issued 50,000 shares of our Series A Convertible Preferred Stock for $1,000 per share. In connection with completing the February 5, 2004 exchange of shares of Series A-1 Convertible Preferred Stock for outstanding 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 during the year ended October 31, 2004.

     With the completion of the repurchase transaction with BayStar Capital II, L.P. (“BayStar”) during the year ended October 31, 2004, as a result of which no Series A-1 shares remain outstanding, we will not be required to continue to accrue or pay any dividends on the Series A-1 shares. As a result of completing the repurchase transaction with BayStar, we recorded a capital contribution classified as a preferred stock dividend in the amount of $15,475,000, which represented the difference in the carrying value of the Series A-1 shares and accrued dividends less the fair value of the 2,105,263 shares of common stock and the $13,000,000 in cash. No dividends were paid on the Series A or Series A-1 shares.

     The following table details the components of the dividends for the years ended October 31, 2006, 2005 and 2004:

     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.

     Factors that may affect quarterly results include:

     As a result of the factors listed above and elsewhere in the “Forward-Looking Statements and Factors That May Affect 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 expenses, our operating results will be lower than expected.

     Our cash and cash equivalents balance increased from $4,272,000 as of October 31, 2005 to $5,369,000 as of October 31, 2006. During this same time period, our investment in available-for-sale

securities decreased from $6,165,000 to $2,249,000. Total cash and cash equivalents and available-for-sale securities were $7,618,000 as of October 31, 2006. As of October 31, 2006, we also have $8,024,000 classified as restricted cash, of which $5,046,000 is set aside to cover expert and other costs related to our SCO Litigation and $2,978,000 is for royalties payable to Novell for Novell’s retained binary royalty stream. During the year ended October 31, 2006, we expended a significant amount of cash for experts and other costs related to the SCO Litigation.

     We intend to use the cash and cash equivalents and available-for-sale securities as of October 31, 2006 to pursue our SCO Litigation and to run our UNIX business. We believe that based on the combination of our existing cash and cash equivalents and available-for-sale securities as of October 31, 2006, we will have sufficient cash resources to fund our operations for at least the next 12 months.

     Our net cash used in operating activities during the year ended October 31, 2006 was $13,310,000 and was attributable to a net loss of $16,598,000, changes in operating assets and liabilities of $1,440,000, and offset, in part, by non-cash items of $4,728,000. Our working capital decreased from $8,669,000 as of October 31, 2005 to $7,144,000 as of October 31, 2006.

     Our net cash used in operating activities during the year ended October 31, 2005 was $21,507,000 and was attributable to a net loss of $10,726,000, changes in operating assets and liabilities of $13,868,000, and offset, in part, by non-cash items of $3,087,000. Our working capital decreased from $15,413,000 as of October 31, 2004 to $8,669,000 as of October 31, 2005.

     Our net cash used in operating activities during the year ended October 31, 2004 was $22,604,000 and was attributable to a net loss of $23,350,000, changes in operating assets and liabilities of $176,000, and offset, in part, by non-cash items of $922,000. Our working capital decreased from $37,168,000 as of October 31, 2003 to $15,413,000 as of October 31, 2004.

     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 year ended October 31, 2006, cash provided by investing activities was $3,884,000, which was primarily a result of sales, net of purchases, of available-for-sale securities of $3,916,000 and a dividend received from our 30% owned Chinese company of $308,000, offset, in part, by the purchase of property and equipment of $340,000.

     During the year ended October 31, 2005, cash provided by investing activities was $12,255,000, which was primarily a result of sales, net of purchases, of available-for-sale securities of $12,591,000 and the purchase of property and equipment of $336,000.

     During the year ended October 31, 2004, cash used in investing activities was $15,443,000, which was primarily a result of purchases, net of sales, of available-for-sale securities of $14,728,000, purchases of equipment of $506,000 and the purchase of the remaining minority interest in our Japanese subsidiary of $209,000.

     Our financing activities provided $10,425,000 of cash during the year ended October 31, 2006 and was comprised of proceeds, net of offering costs, of $9,809,000 from the sale of common stock in a private placement, proceeds of $613,000 received from the sale of common stock through our ESPP and proceeds of $35,000 from the exercise of options to acquire shares of our common stock, offset, in part, by the repurchase of shares of our common stock made in connection with the completion of our rescission offer of $32,000.

     Our financing activities provided $959,000 of cash during the year ended October 31, 2005 and was comprised of proceeds of $720,000 received from the sale of common stock through our ESPP and proceeds of $239,000 from the exercise of options to acquire shares of our common stock.

     Our financing activities used $13,864,000 of cash during the year ended October 31, 2004. The primary uses of cash were $13,000,000 for the repurchase and retirement of shares of our Series A-1

Convertible Preferred Stock, $2,414,000 for the purchase of shares of our common stock on the open market, and $211,000 paid in connection with the issuance of Series A-1 shares in exchange for outstanding Series A shares. These uses of cash were offset, in part, by proceeds generated from the exercise of options to acquire common stock of $951,000 and proceeds of $810,000 received from the sale of common stock through the ESPP.

     Our net accounts receivable balance decreased from $6,343,000 as of October 31, 2005 to $5,123,000 as of October 31, 2006, primarily as a result of lower invoicing during the three months ended October 31, 2006 as compared to the three months ended October 31, 2005. The majority of our accounts receivable are current and our allowance for doubtful accounts was $106,000 as of October 31, 2006, 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 years ended October 31, 2006, 2005 and 2004 were not significant.

     As described elsewhere in this Form 10-K, we are continuing to pay for expert, consulting and other expenses relating to our litigation with IBM. These expenses have been material for the years ended October 31, 2006, 2005 and 2004. For the year ending October 31, 2007, we expect that these expenses will decrease, but will continue to be material to our financial statements and cash position.

     In addition to the cash expenditures mentioned above, we must also pay one or more contingency fees upon any amount we or our stockholders may receive as a result of a settlement, judgment, or a sale of our company. The contingency fee amounts payable to the Law Firms will be, subject to certain credits and adjustments, as follows:

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

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

     The following table summarizes our contractual operating lease obligations as of October 31, 2006:

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

     Our ability to reduce costs to offset revenue declines in our UNIX business is limited because of contractual commitments to maintain and support our existing UNIX customers. The decline in our UNIX business may be accelerated if industry partners withdraw their support as a result of the SCO

Litigation. In addition, the SCO Litigation may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products. This would lead to an accelerated decline in our UNIX products and services revenue. If our UNIX products and services revenue is less than expected, our liquidity will be adversely impacted.

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

     In July 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” or FIN No. 48. FIN No. 48 prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN No. 48 provides guidance on the de-recognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The provisions of FIN No. 48 will become effective for us beginning November 1, 2007. We are currently evaluating the impact that FIN No. 48 will have on our results of operations, financial position or liquidity.

     In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” or SFAS No. 157. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently evaluating the impact that the adoption of SFAS No. 157 will have on our results of operations, financial position or liquidity.

     In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” an amendment of FASB Statements No. 87, 88, 106 and 132(R). SFAS No. 158 requires recognition of the over funded or under funded status of defined benefit pension and other postretirement plans as an asset or liability in the balance sheet and changes in that funded status to be recognized in comprehensive loss in the year in which the changes occur. SFAS No. 158 also requires measurement of the funded status of a plan as of the date of the balance sheet. The recognition provisions of SFAS No. 158 are effective for the fiscal year beginning November 1, 2006, while the measurement date provisions are effective for the fiscal year beginning November 1, 2008. The adoption of SFAS No. 158 is not expected to have a material impact on our results of operations, financial position or liquidity.

     In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements,” or SAB No. 108, which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB No. 108 is effective for financial statements issued for fiscal years ending after November 15, 2006. The adoption of SAB No. 108 is not expected to have a material impact on our results of operations, financial position or liquidity.

     With the exception of historical facts, the statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which reflect our current expectations and beliefs regarding our future results of operations, performance and achievements. The section entitled “Business” above in Part I, Item 1 of this Form 10-K also includes forward-looking statements. These statements are subject to risks and uncertainties and are based upon assumptions and beliefs that may or may not materialize. These forward-looking statements include, but are not limited to, statements concerning:

     We wish to caution readers that our operating results are subject to numerous risks and uncertainties that could cause our actual results and outcomes to differ materially from those discussed or anticipated, including the failure or adverse developments in the SCO Litigation, competition from other operating systems, particularly Linux, the amount and timing of SCOsource licensing revenue, our ability to maintain our UNIX operating systems and maintain our UNIX business, and the factors set forth in the subsection entitled “Risk Factors” under Part I, item 1A of this Form 10-K. We also wish to advise readers not to place any undue reliance on the forward-looking statements contained in this report, which reflect our beliefs and expectations only as of the date of this report. We assume no obligation to update or revise these forward-looking statements to reflect new events or circumstances or any changes in our beliefs or expectations, other than as required by law.

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

dollars. Our revenue can also be affected by general economic conditions in the United States, Europe and other international markets. Our results of operations may be affected in the short term by fluctuations in foreign currency exchange rates.

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

     Investment Risk. We have historically invested in equity instruments of privately held and public companies in the technology industry for business and strategic purposes. Investments are accounted for under the cost method if our ownership is less than 20 percent and we are not able to exercise influence over operations. Our investment policy is to regularly review the assumptions and operating performance of these companies and to record impairment losses when events and circumstances indicate that these investments may be impaired. As of October 31, 2006, we did not hold any cost method investments.

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

The Board of Directors and Stockholders
     The SCO Group, Inc.:

     We have audited the consolidated balance sheets of The SCO Group, Inc. and subsidiaries as of October 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive loss, stockholders’ equity and cash flows for the years then ended. Our audits also included the financial statement schedule as of and for the years ended October 31, 2006 and 2005 listed in the Index at Item 8. These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits.

     We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The SCO Group, Inc. and subsidiaries as of October 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. Also in our opinion, the financial statement schedule for the related years, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

Salt Lake City, Utah
January 26, 2007

The Board of Directors and Stockholders of
     The SCO Group, Inc.:

     We have audited the accompanying consolidated statement of operations and comprehensive loss, stockholders’ equity and cash flows of The SCO Group, Inc. and subsidiaries for the year ended October 31, 2004. In connection with our audit of these consolidated financial statements, we have also audited the related financial statement schedule. These consolidated financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and the financial statement schedule based on our audit.

     We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

     In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and the cash flows of The SCO Group, Inc. and subsidiaries for the year ended October 31, 2004 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

Salt Lake City, Utah
February 18, 2005
except as to Note 16,
which is as of March 11, 2005

CONSOLIDATED BALANCE SHEETS

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS