December 29, 2003 - 6:18pm EST by
2003 2004
Price: 17.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 290 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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SCO Group (Ticker: SCOX) is an extremely interesting litigation driven special situation, and also almost certainly not everyone’s cup of tea. It is binary, complicated, very controversial, and in the absence of its legal claims, hugely (we think 100%) overvalued. But we think those legal claims have an expected value that is multiples of where the stock is currently trading, and various catalysts exist that might drive price appreciation in the relatively near term. If you are willing to own interesting call options and also willing to get into the soup in this kind of thing, it is, in our view, very compelling.

Legal Claims: SCO’s version of the story: SCOX owns the source code to Unix System V, which is a version of the Unix operating system, upon which various proprietary operating systems including IBM’s AIX, HPQ’s HP-UX and Sun’s Solaris are all built. SCOX alleges that the Linux kernel (the heart of the Linux/GNU operating system) infringes SCOX’s copyright property in Unix Sys V in 2 main ways. First, hundreds of thousands of lines of code in the Linux kernel are alleged to have been outright copied (digit for digit, including typos) from Unix Sys V to Linux. Second, and more importantly, a large portion of Linux’s crucial functionality is alleged to have been built on top of Unix Sys V. Because this Linux code is so intertwined with Unix Sys V, it is alleged to be a derivative product of it, and thus also property of SCO, under copyright law.

Linux: SCO’s claims are a very big deal in the technology industry, because of the rapid growth of Linux in the enterprise IT market. As most of you know, Linux is free, open source software. Linux was first created by a relatively small group of independent programmers who collectively contributed code on the basis that access to the code should be shared equally by all interested parties. As Linux’s functionality (its ability to handle tasks, allocate memory, process transactions) has improved, Linux has increasingly become a competitive alternative to Windows and even Unix as a base for corporate application development and deployment. Industry analysts estimate that the 2.5 million Linux servers powering inter- and intranet websites currently will grow by approximately 40% for the next 5 years.

Importantly, not all of SCO’s claims tie to copyright infringement. SCO, as the owner of a version of the Unix source code, has license agreements with the major developers of Unix (IBM, HPQ, SGI, SUNW) which have enabled those developers to develop their own proprietary versions of Unix. Those developers, and especially IBM, have openly contributed large portions of their proprietary code to the Linux kernel, in order to enhance the functionality of the kernel, and promote Linux share gains versus Windows. SCO argues that by openly contributing portions of AIX, for example, to Linux, IBM has acted in breach of IBM’s license agreement with SCO on the Unix Sys V license. SCO has sued IBM for breach of the agreement, and has a trial date of April 2005 set, in front of a Utah jury, with a complaint asking for in excess of $3 billion in damages. Full stop. We look at these kinds of special situations as our business, and frequently confront lawsuits asking for ridiculous numbers advancing ridiculous theories. The American legal system is under siege as a result of such abuses. It is our firm point of view that the size of the claim is not ridiculous, and the substance of the claim is not ridiculous. Let me elaborate.

Market Size: SCO has also gone to the other major Unix vendors, making similar arguments. HPQ and SCO were in settlement talks, with a view toward HPQ re-licensing Unix Sys V to cover HPQ’s contribution of HP-UX code to the Linux kernel. Those broke down over price (and the parties were far apart). SCO has since gone out to the Fortune 1000 notifying the corporate IT world of SCO’s claims, and announcing that in the absence of Linux users licensing Unix Sys V from SCO, corporate Linux users are themselves subject to litigation from SCO. One undisclosed corporation has signed a license with SCO, but most have waited, so far. Large technology companies have a vested interest in seeing Linux grow. In order to prevent SCO from freezing the Linux market, HPQ has offered an indemnity against SCO’s claims to HPQ Linux customers, if those customers are willing to pay an incremental $700 per CPU. So if you own a HPQ server and run Linux on it, and if you pay HPQ $700 per CPU on the server, HPQ will cover you if SCOX sues you for copyright infringement. (The HPQ indemnity only protects corporations who run HPQ versions of Linux, and as such, provides very limited protection. In our view, as a result, there have been few if any takers of HPQ’s indemnity offer). One way to size the alleged copyright infringement is to use HPQ’s $700 per CPU, on 2.5mm servers, growing 40% per year. SCO has since offered the same $700 per CPU price to corporate Linux users, saying pay us a royalty, and we won’t sue you. Again, at this point, corporate users in general: 1) Think Linux is a big deal; 2) Are increasingly aware of SCO’s claims; 3) Don’t know if SCO’s claims are valid; and 4) Are adopting a wait-and-see attitude, waiting for progress on the IBM suit (which is the only suit filed thus far) to see who is right. By its nature as royalty income, any license revenue for SCO is all incremental margin. IBM’s alleged license agreement infringement is one source of the infringement of SCO’s copyright, so the $3 billion IBM lawsuit number is not ridiculous.

Take a very big step back from the detail. To us, what is clear is the following: Linux is a big deal. If Linux infringes SCO’s copyright, SCO’s copyright is very valuable. We don’t know if SCO’s copyright is worth $1 billion or $10 billion, but if what SCO alleges is right, it is worth many multiples of where the stock trades. Another way to look at the size of the claims is to guestimate how much license revenue SCO might generate in a reasonable period of time. After getting little reception to their royalty offer from corporate Linux users, SCO is in the process of preparing lawsuits against those users for copyright infringement. If Linux infringes SCO’s copyright, end users are liable under the Digital Millenium Copyright Act, and lawsuits might spur royalties. By the end of next year, there will be 3.5mm Linux servers, at 4 CPUs per server, running Linux applications. $700 per CPU per year can get you to some very large numbers. Again, this $700 price was set by a potentially large infringer trying to soothe customer concerns, and so far soothing very little.

Probability: So is SCO right? The most important points we make here are the following: One, the answer is not clear. And two, a lot of very smart legal analysts think they are, or that there is a very substantial chance they are. When we do a detailed analysis of the arguments against SCO’s claims, we come away with a number of tentative conclusions, all pending further information and disclosure that will come with additional litigation developments. But what is very clear is that there is some significant substance to SCO’s claims. SCO, based in Utah and controlled by a private investor who owns 35%+ of the stock, are not a bunch of crazies. An awful lot of what they argue makes sense. I detail a partial list of critic arguments and responses below.

Second, SCO management are not purely hype-driven cheer leaders, and they have a great lead lawyer. David Boies is the plaintiff attorney directing all of the SCO legal strategy and litigation. In our view, Boies is one of the best litigators in the country, and the perfect guy to lead SCO’s claims. Boies is a former Cravath Swaine and Moore partner. Cravath is a blue shoe NY law firm, maybe the blue show NY law firm. One of Boies’s major litigations at Cravath was his defense of IBM in the US government’s decade long antitrust litigation against IBM. He knows IBM well, and knows what it means to sue IBM. His new firm has 200 lawyers, and is working on contingency on the SCO claims. Boies gets 20% of all proceeds from all intellectual property litigation won by SCO, including 20% of the proceeds of the sale of the company in settlement of the legal claims. Boies sits in our shoes, and his lending his time and resources to this endeavor is a wonderful confirmation, for us, of the work we have done convincing us that there is real substance to what SCO is talking about.

Still, most people think the SCO claims are bunk, and they think so loudly. The vociferousness with which the open source community opposes SCO’s claims is very extreme. SCO’s executives routinely receive death threats. Seriously. SCO’s web site experiences frequent denial of service attacks. Deutsche Bank recommends the stock (and their report is quite good, if you can get your hands on it), and Linux enthusiasts now target the DB website as well. My personal favorite: The short interest on the stock is 30% of the float, and 15 days of trading volume. Critics make the following arguments

SCO does not own the Unix Sys V source code. SCO bought the code from Novell, which bought it from AT&T. SCO does not own what was contributed to the public domain before SCO bought the code from Novell. AT&T contributed a large portion of the source code to the public domain prior to its sale to Novell. Our take: SCO does not all of Unix Sys V, but they clearly own part of it. Part of it is enough for SCO’s claims to be very weighty.

There is not significant outright copying of Unix Sys V in Linux. Our take: We have seen it. It is there. Not a concern of ours.

The outright copying can be designed around. Our take: The question is how much can be over what period of time. We think a defense of design around is a concession of infringement, which merits some compensation at a minimum, and we think that potential alone justifies the stock price. The design around risk speaks to the upside potential of the investment. There are approximately 1 million lines in the Linus kernel, and there is at least 100,000 lines of alleged outright copying. The scale of the copying suggests the potential to design around it is limited. The severity of the Linux community’s response to SCO’s claims also suggests designing around copied code ain’t easy. If it were, why hasn’t it happened already?

Unix Sys V is worth little. Most of what was contributed to Linux was proprietary Unix code developed by IBM, HPQ & others. IBM owns that code, and can do with it what it wants. This is the main defense to SCO’s claims that IBM makes, and this is what has thus far kept many corporate Linux users from paying SCO for licenses. Our take: Close call. Repeat, not a joke, close call.
The key question is what is a derivative work in software for purposes of US copyright law. If I write a novel, and you simply copy my novel, and sell your copied book, you have infringed my copyright. That is clear. If you write a screenplay based on my novel, have you changed enough of the material to have created something original, that you own, that is your copyright? No, settled question under the law, screenplays based on novels infringe, unless written with the consent of the novelist. Your screenplay is a derivative work of my novel. If you write a parody of my novel without my consent, have you infringed? No, parodies are original works, another settled question. Is AIX an original work, or is it derivative of Unix Sys V? Or better put, is all of AIX original, or are there pieces that are derivative, and how important are those pieces, and are they in Linux? That is main legal question at issue with SCO. If SCO is right, we think the company is worth billions of dollars. If IBM is right, it is worth, in our view, nothing.

Financials: Oh yeah, the fundamentals. SCO has a business, they sell software, versions of Unix and applications based on their code, but it burns cash, has little future, and we value it at zero. The company is the litigation.

SCO did a convert in the 4th quarter and raised $50 million in cash. In addition to some license revenue from SUNW and MSFT, the convert brought SCO’s cash balance to $64 million at year end. (The SUNW & MSFT licenses were one time events). This number is relevant, because SCO has to finance the IBM lawsuit, as well as litigation that SCO will announce in the next 2 months against some high profile Linux users who thus far refuse to license Unix Sys V from SCO. Again, Boies is the lawyer on these suits as well. The convert is at the money. There are 17mm fully diluted shares. Boies gets 20% of the take from the lawsuits. At $17.25, you are paying $290 million for the equity. We value the cash at zero, assuming that it gets spent trying to prove the claims, and is gone if SCO is ultimately discredited.

So on our math, the stock values the legal claims at approximately $350 million. If SCO is right, we think the stock is easily worth 3 times that amount, and very likely a lot more. The IBM lawsuit alone asks for 9 times that amount. We think there is much greater than a 1/9 chance that SCO wins the IBM case. We think there is much greater than a 10% chance that there is meaningful copyright infringement here. More lawsuits are coming, from one of the nation’s best litigators, against some of the best capitalized companies in the world, who care about Linux deeply, and thus care about what SCO is saying very much. Are these companies willing to bet billions of dollars that their lawyers are making the right close call on a legal question with little precedent? Are they going to successfully soothe customer concerns once those customers are also the direct targets of lawsuits making the related arguments? SCO is not going away anytime soon, they have the liquidity now, am I making a bet on the lawsuits, or is a settlement a reasonable possibility?

One last point: We think this is a hugely interesting litigation driven special situation, and that there is significant expected value in the stock. I could go on, and am happy to if there are questions. But I would just ask the following. SCO has received so much mis-attention, and hype, and criticism, that it is sometimes hard for some to get past all of it If you are inclined to look at situations like these, I urge you to spend 5-10 hours on this one, and make up your own mind.


Litigation against corporate Linux users; litigation against IBM; royalty license deals; major litigation settlements.
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