A Linux Nemesis on the Rocks


By Spencer Ante Two years ago, a tiny Utah company maneuvered its way into the biggest software battle on earth. On one side was mighty Microsoft (MSFT). Challenging the giant was the Linux operating system, built and maintained by legions of volunteer programmers around the world -- and supported by none other than IBM (IBM). Standing between them was SCO Group (SCOXE), a struggling software company in Lindon, a small town 30 miles south of Salt Lake City.

While short on business, SCO held some potentially powerful copyrights. Partly funded by a hefty Microsoft license payment, SCO leveled a multibillion-dollar suit against IBM, charging that Big Blue had fed SCO-copyrighted software into Linux. This triggered fear and loathing in the fast-growing Linux community. A court win for SCO, Linux fans feared, could bring its growth to a grinding halt. And so, SCO became one of the most vilified companies in the technology industry.

MISSED DEADLINE. Well, the mouse that roared is barely squeaking these days. A string of recent setbacks raises grave questions about SCO's finances, its court case, and its management. In December, Canopy Group, SCO's biggest investor, fired two of its top executives -- who are also the chairman of SCO's board and a SCO director. Later, in a lawsuit, it accused them of overpaying themselves by at least $20 million as Canopy execs -- charges they have denied.

And on Feb. 9, U.S. District Court Judge Dale A. Kimball scolded SCO for failing to produce any evidence proving IBM infringed its copyrights. A week later, Nasdaq warned SCO that it could be delisted for failing to file its annual financial statement.

SCO says it missed the filing deadline over issues relating to the accounting of its common stock and equity compensation plan. As a result of adjustments to its accounting, SCO will be restating its earnings for the first three quarters of 2004, BusinessWeek has learned. While the restatements won't change its net loss or cash balance for that year, they are likely to reduce its cash position by $500,000 or more in fiscal year 2005, says an insider.

SOME STAYING POWER. What once looked like a mortal threat to Linux appears to be fading. As a result, the suit has become a nonfactor in corporate buying decisions. "I can't imagine how this will go anywhere," says Alex Dietz, chief information officer at Acxiom, a Little Rock consumer-data-analysis company that uses Linux.

Microsoft, which helped finance the SCO lawsuit by paying $13 million to SCO for a Unix license, claims that Linux, which is available free of charge, costs more to maintain than its own Windows operating system. That tactic doesn't seem to be working, either: In 2004, Linux server computer sales grew 51%, to $4.9 billion, according to Gartner. Microsoft would not comment on SCO but has said in the past that it bought a SCO license to make sure Unix worked with Windows -- and not as a way of financing SCO's suit.

Weak as it is, SCO has some staying power. Late last year the company recrafted an agreement to cap its legal fees with its outside law firm, Boies, Schiller & Flexner, ensuring that the lawyers will continue to press the case without draining SCO's reserves. The agreement should leave the company with about $7 million in the bank for fiscal year 2005.

LITTLE EVIDENCE. Indeed, SCO Chief Executive Darl C. McBride remains optimistic. "It's a crazy environment we live in," says McBride, "but we're in pretty good shape." Thanks to heavy cost-cutting, SCO's core Unix-server-software business is generating an operating profit now and will continue to do so in 2005, he says. What's more, McBride says the release this summer of a major upgrade of one of its Unix products will help boost its sales. Still, he admits that SCO's growth prospects hinge on its legal efforts. They "will define how we end up in this game," he says.

SCO dodged a legal bullet when the U.S. District Judge refused in February to grant IBM's request for a summary judgment. But so far, SCO has failed to produce evidence for the court, despite numerous claims that it had ample proof of IBM misdeeds. In addition, nothing incriminating has shown up so far in 900 million lines of software code that IBM has turned over to SCO.

"It is astonishing that SCO has not offered any competent evidence to create a disputed fact regarding whether IBM has infringed SCO's alleged copyrights," wrote Judge Kimball. Thomas C. Carey, a lawyer at Boston law firm Bromberg & Sunstein who is not involved in the suit, says SCO's case is on the ropes. "The judge gave every indication that he is prepared to throw out the case unless SCO comes up with some surprising evidence," he says.

SHRINKING CORE. SCO hopes its case will be saved by further documents from IBM. In January, Magistrate Judge Brooke C. Wells ordered the computing giant to hand over an additional 1.1 billion lines of code, as well as information about revisions to the code and the names of 3,000 programmers who helped develop versions of AIX and Dynix, two of IBM's Unix-based operating systems. It will take SCO several months to review this code and depose IBM developers.

Meanwhile, analysts expect the company's core business to keep shrinking. For the fiscal year ended Oct. 31, 2004, SCO announced sales of $42.8 million -- down 46% from the year before. Losses more than tripled, to $16.2 million. For fiscal 2005, Decatur Jones Equity Partners expects SCO to report an $11 million loss on $38 million in sales.

As a result, SCO has been forced to cut staff. Last year, it laid off about 100 employees, a third of its workforce. With each layoff, analysts say its ability to produce and sell software is diminished. "This is a sinking boat," says Decatur Jones's Dion Cornett, the only analyst on Wall Street tracking SCO. McBride says that while his staff is small in numbers, it's high on engineering expertise.

CHANGES DOWN THE ROAD? Adding to SCO's uncertainties are the woes at Canopy Group, which owns 31% of its shares. In December, Canopy's board fired Chief Executive Ralph J. Yarro III and Chief Financial Officer Darcy G. Mott. The two men sued, alleging illegal dismissal. Yarro and Mott claim their compensation was approved by Canopy's board. McBride says they will remain on SCO's board pending the outcome of the dispute.

Canopy lawyers say they are not trying to remove Yarro and Mott from the SCO board at this time, but some analysts say the feud could lead to changes in SCO's management or strategy down the road. If new directors are appointed at Canopy's request, they might pressure SCO "to sell assets or force a settlement," says analyst Rob Enderle of market researcher Enderle Group.

SCO's prospects could become clearer in a few weeks. On Mar. 8 a judge will begin a hearing that could help clarify who controls Canopy. On Mar. 17, SCO is set to defend itself against delisting in a hearing before Nasdaq. Then on Mar. 18, IBM is supposed to turn over the new code and other material. The judge has said he will allow IBM to file another motion to dismiss the case after this next phase of discovery is completed.

If SCO survives the next round, the court case will probably drag on. It was once scheduled to go to trial in early 2005. That was later shifted to November. But now it will be pushed back into 2006. This case may be long forgotten when, and if, it ever goes to trial. With Steve Hamm in New York

Ante is Computers editor for BusinessWeek in New York


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