How To Play Delinquent Stocks

• March 17, 2005
• Melanie Hollands

SCO Group
www.sco.com, (ostensibly) a software company, was recently marked as delinquent
by the NASDAQ for failure to file its 10K in a timely manner. I’ve heard chatter
about playing SCOXE on the long side in anticipation of the company restoring
its filing status; and playing it short if it doesn’t.

I’ve
thought about this kind of trade a few times in the past. Personally, I’ve never
traded delinquent stocks with the scarlet letter “E” on the end. And, in this
particular case, a failed filing of a 10K has too many variables from a trading
perspective to properly manage risk. Being ‘close’ to original company sources
and insiders to know what is ‘really’ going on helps remove much of the risk –
i.e., knowing that the company:

·    
isn’t a phantom
company and won’t disappear altogether,

• will
  get back in compliance in a specific timeframe, and
• is
  experiencing a temporary ‘blip’ in operations and that its noncompliance seems
  to be a one-time event.

   

This all supports the speculative trading strategy from the long side, which I'd agree with; and in my watching these types of plays unfold, this is usually what happens. 

That said,
betting on a delinquent stock redeeming itself isn’t the type of trade I’d take.
Although, technically, I think the elements are in place for a shorter-term long
side trade in SCOXE:

·         the stochastics (a directional indicator) are pointing higher,

·         SCOXEs early morning (Tuesday, March 15) volume is indicating a surge is happening and buyers are dominating,

·         the stock has held its three-month base strongly, and 

•  
  if it closes anywhere near $4.25, then that will print a “hammer” candle and
  that’s bullish.

Fundamentally, however, I don’t like SCO Group. SCO is the company formerly
known as Caldera. SCO is essentially owned and run by The Canopy Group, a Utah
firm with investments in dozens of companies. Canopy’s CEO, Ralph Yarro, is
Chairman of SCO’s Board of Directors. (Yarro engineered the 1996 lawsuit against
Microsoft.) Darcy Mott, Canopy Group’s CFO, was another SCO director as was
Thomas Raimondi, CEO of MTI Technology owned by Canopy Group.

SCO is
supposed to be a software company; but its business model is really firing
bullets at the Linux community. SCOs most high profile lawsuits are against IBM,
Novell, Daimler-Chrysler, AutoZone, and Red Hat versus SCO. The legal basis for
SCOs various claims is (like most legal cases in IP) long-winded and
complicated. But basically, the company claims that Linux is a violation of
portions of the UNIX code (or more accurately, SCO / UNIX code) which it
maintains that it owns. 

Last week,
SCO announced that it will restate its financials – in part because SCO had not
fully complied with certain securities laws – for the fiscal quarters ending
January 31, 2004; April 30, 2004; and July 31, 2004. 

SCO had failed
to file its annual Form 10-K for the fiscal year ending October 31, 2004. On
February 16, the company received notification from the

NASDAQ that it
was not in compliance with the exchange’s listing requirements. The 10K was due
on January 31, 2005, as the SEC requires filing within 90 days of fiscal
period-end (in SCOs case October 31, 2004). SCO filed for a 15-day extension,
which expired on Tuesday, February 15. Consequently, the NASDAQ considered SCO
Group to be a delinquent filer and added an “E” to the end of its former SCOX
ticker (like a scarlet letter) to signal that status to the market. SCO’s stock
started trading under the symbol SCOXE on Friday, February 18. Meanwhile, SCO
requested a hearing before the NASDAQ Listing Qualifications Panel to appeal the
exchange’s determination. SCOXE common stock will remain listed on the NASDAQ
pending the outcome of the appeal. However, if SCO Group had continued to fail
to comply with the NASDAQs reporting requirements, its listing on the exchange
could have been in jeopardy and it was possible SCOXE could have been be
de-listed from the exchange.

The
restatements will involve SCO doing the following (as extracted from the press
release): 

 

·        
Reclassify dollar
amounts related to shares of common stock that SCO Group may have issued under
its equity compensation plans without complying with the registration
requirements of federal and applicable state securities laws in the amounts of
approximately $272,000, $231,000, and $557,000. 

·        
Reclassify
accrued dividends (related to its previously issued Series A and Series A-1
convertible preferred stock) from equity to current liabilities in the amounts
of approximately $879,000 and $1,619,000. In October 2003, SCO Group issued
shares of Series A convertible preferred stock in connection with its $50
million PIPE deal; those shares were subsequently exchanged for, and replaced
by, shares of Series A-1 convertible preferred. When SCO Group repurchased all
outstanding Series A-1 shares in July 2004, its obligation to pay dividends on
those shares terminated. The accrued dividends were never paid and ultimately
were recorded as equity rather than as liabilities upon the completion of the
repurchase. 

·        
Restate $233,000
of stock-based compensation expense, which was recorded in the second quarter,
but incurred in the first quarter. There will be no change to the total
stock-based compensation expense for the fiscal year ended October 31, 2004. 

 

Once the
restatements are complete, and reviewed by the company’s auditors KPMG, SCO
Group will file amendments to its quarterly 10Qs for the relevant periods and
will also file its now long overdue annual 10K for its fiscal year ended October
31, 2004.

My own
view is these restatements are due to practice that is a touch shady, but not
outright fraud. However, restating for these reasons isn’t what I would call a
“routine” restatement; so it doesn’t pass the smell test for what I would call
“good company practices”.

On April
20, 2004, SCO had issued stock- and option-based compensation to certain
employees during these periods. SCO Group management said last month that the
delinquency in filing its 10K was related to accounting treatment for stock
options. Well, as it happened on April 20, 2004, SCO Group

filed a number of
registration documents granting options to seven of its senior
executives. The executives included the (then new) CFO Bert Young and the
following members of its Board of Directors: Duff Thompson, Fred Skousen, Ralph
Yarro, Darcy Mott, Daniel Campbell, and Edward Iacobucci. Yarro and Mott have
since been fired from the board of SCO’s parent company, Canopy, in a separate
— and well-chronicled — power struggle. They have filed suit to be reinstated.

I’m no fan of SCO Group
and its various business practices. But in this matter, these items would be
more a matter of minor indiscretions rather than major. That said, it’s my view
that there is more to come… Now, SCO Group has not, to the best of my knowledge,
been delinquent in the past with filings. But that doesn’t necessarily mean its
past filings have been correct or that the auditors haven’t been helping cook
the books. It’s not unheard of for companies to be late filing. And while it’s a
serious development, the reasons may or may not be “very serious” — like fraud,
accounting shenanigans, etc. However, recall that one of SCOs board members,
Thomas Raimondi, left the firm a couple of months ago. Just speculating here,
but perhaps Raimondi left for not wanting to verify this kind of stuff? Just a
hypothetical. And in December, 2004, Canopy Group’s CEO, Ralph Yarro, and the
CFO, Darcy Mott, were fired from Canopy – SCOs parent company. Oddly, the
management shakeup affected Canopy Group, not SCO: Yarro remained Chairman of
the Board, Mott remained as a Board member board member and Canopy continued to
be a majority shareholder of SCO Group. But I often wonder when senior
executives leave a troubled firm, or its parent company, and then the company
becomes a delinquent filer…

SCO
Group’s fundamentals aren’t improving (confirmed by the abysmal results SCO

reported December 21)
and sustainable stock price appreciation seems unlikely. SCO core business isn’t
growing, and there’s not much evidence of much potential for its licensing
program. Furthermore, a negative outcome of the IBM and its other lawsuits is
likely to be another nail in the coffin at SCO.

Melanie
Hollands 

melaniehollands@yahoo.com