SCO Gets Lift in Form of ‘Buy’ Rating

It isn’t often that court happenings weigh heavily enough to influence a
company’s stock, but that’s exactly what could happen to SCO Group, an
investment firm said Wednesday.

Despite all of the negative attention it has
received from the brouhaha it touched off by laying a claim to Linux
copyrights, the SCO Group was praised by Deutsche Bank with a “buy” rating and projected stock price of $45.

The investment bank issued the price target — more than an 180 percent
upside potential from the Tuesday level of nearly $16 — on the
Lindon, Utah-based company, which earlier this year filed
suit against IBM, charging that it had made confidential Unix code available to the open source community. IBM countersued SCO and since then a rash of legal fireworks
have littered the open-source realm.

The news sent SCO’s stock into the stratosphere on Wednesday but perhaps not without some help: insiders unloaded another 131,000 shares, including stock held by Vultus, whose assets were acquired by SCO in June, Angel Partners, and four others.

While analysts Brian Skiba and Matthew F. Kelly, who authored the report, describe any
investment in SCO as risky, they are encouraged by the potential for
benefits SCO could derive out of the lawsuit. However, they also recognize
the potential for a penniless stock as well.

“We view SCOX as a call option on a substantial lawsuit against IBM and the
potential to capitalize on Linux,” the authors wrote. “Investors should consider an investment in
SCOX as extremely high risk that may yield a substantial return or may
collapse in value. Investors with an appetite for risk should, in our view,
see an investment in SCO Group as the equivalent of a call option – with
most of the risks and rewards often associated with options. The IBM lawsuit
and the potential for Linux licensing deals offer plenty to be excited
about, while failure could render the shares worthless, in our view.”

The authors claimed that if SCO is successful at licensing its intellectual
property (IP), fixed costs and a small share count would create great
leverage with regard to earnings-per-share (EPS). The firm sees revenue and
earnings estimates as $82 million and $1.00 EPS for 2003, respectively, and
estimates of $116.5 million and $2.29 EPS for 2004.

That’s the potential upside. The authors also described the potential downside for SCO, which was recently ranked number 75 on the 2003 Deloitte Technology Fast 500, a ranking of the 500 fastest growing technology companies in North America.

“The largest risk is that SCO Group’s claims be without legal merit,” Skiba
and Kelly said. “We are not lawyers and are not attempting to predict the
outcome of this legal case, however, should this lawsuit be without merit,
it would be a huge blow to the shares. We believe the stock will be
extremely volatile, due to constant newsflow and a small share count. Swings
of +/- 20% in a single day could be expected. A lawsuit against a large and
rich company such as IBM is a dangerous undertaking, and it could cause SCO
to overextend its legal reach and budget. In addition, SCO is being sued by
Red Hat. This lawsuit is a risk and we imagine SCO could be the focus of
other lawsuits, as its legal actions could be interfering with Linux
business at many companies.”

But if SCO wins the $3 billion lawsuit, the authors said the company would
have a cash award of over $185 per diluted share. IBM would face significant
legal damages not only based on their code contribution, but on their entire
AIX business for two years (estimated time between license cut-off and the
trial). If the Linux code base is deemed to be tainted, then SCO would be
free to seek damages against the millions of users of the Linux operating

And if SCO loses, Skiba and Kelly believe the company’s value would be
marginal and well below the current valuation. An alternative way to look at
the SCOX situation is as a “straddle” as opposed to a pure call.

“Rather than assuming the stock goes to zero, the management could decide to
strike more aggressive licensing arrangements with key ox vendors and
perhaps settle all issues with IBM at a bargain price. On such a strategy,
we would expect the stock to support a higher price than zero, perhaps $15
per share. In summary, while the downside risk is to zero, from the current
market capitalization of $200 million, the upside potential is equally

In closing the report, the authors said: “We have our doubts about the IBM
lawsuit actually getting to trial in 2005. Nonetheless, SCO has little to
lose by waging this battle, and sentiment around SCO’s chances of legal
success is likely to swing dramatically causing huge volatility in the
stock. A takeout of the company remains an alternative exit for investors,
particularly if the firm is able to slow down the adoption of Linux among
major enterprises. While IBM has steadfastly refused to negotiate any
potential new contract with SCO, we continue to believe it could be a buyer
of last resort for the company should its case look stronger over the next
18 months.”

Stacey Quandt, principal analyst for the Open Source Development Lab, called the DB report a useful guide in understanding the high risk to investors and the speculative nature of SCO stock.

“SCO is putting itself in contention with its customers,” Quandt told in an e-mail interview. “The Microsoft and Sun licensing agreements provided the company significant revenue. A question to ask is how likely is it that other companies will follow? Given the growing adoption of Linux with
increasing enterprise capabilities it is doubtful that other IT firms will participate.
Ultimately the SCO lawsuit against IBM will mostly likely amount to a small footnote in the broader history of Linux maturation and use.”

Back Story

Though the whole convoluted issue has been in debate behind the scenes as IBM and SCO had tried to work things out in a civil manner, this proved to be impossible. SCO touched off the legal war last March when it filed suit against IBM, alleging misuse of Linux in its proprietary version of the Unix operating system, AIX.

IBM countersued in August, filing a lawsuit late Wednesday in a Utah court claiming that SCO’s case breaches contract with IBM, infringes on its patents and signifies unfair competition, among other things. Since then, a number of sticky legal entanglements have ensued between SCO and other vendors who employ Linux, including Red Hat and SGI.

How did it all start? What is the basis of SCO’s claim? The evolution of Unix from then to now is complex. Once known as Caldera Systems, SCO was formerly a distributor of Linux but ended up owning the rights to Unix after a series of acquisitions, including the outright purchase of the Unix rights from Novell in 1995. This included the code base from Unix’ creator, AT&T, who had in turn sold the rights to Novell two years previously.

Meanwhile, AT&T and IBM had entered an agreement in September 1985 where IBM became a licensee of UNIX from AT&T. In short, IBM and SCO have a binding relationship that defines IBM’s rights and responsibilities with regards to the UNIX system V operating system. However, some ambiguity existed in the SCO/Novell transaction, opening the door for this whole case.

Linux, an open-source OS that closely resembles Unix in structure and code base, has been slowly replacing proprietary Unix systems with IBM leading the way, championing the value of Linux over Unix.

Consequently, Unix has declined in value proportionately to the rise of Linux. SCO claims in its legal documents that it has been deliberately injured by IBM and others to destroy the value of UNIX by hyping Linux as an alternative to UNIX in the enterprise world. SCO has since contended that IBM has violated its UNIX agreement, and revoked IBM’s license for UNIX that is used as the basis for AIX. IBM believes its license is valid.

This was all debated behind the scenes from some time. Ultimately, failing to reach an agreement, SCO embarked on its legal campaign versus IBM and other Linux-based companies. Moreover, it has said it would go after individual users, raising the ire of the Linux community.

But it isn’t entirely the Linux-using world versus SCO. Microsoft and Sun both struck licensing arrangements with SCO, trying to position themselves strategically regardless of what the outcome is.

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