SCO Group Soars on Upgrade - TheStreet

Shares of

SCO Group


skyrocketed to their highest level in nearly three years after a Wall Street brokerage firm initiated coverage of the stock with a buy rating.

Deutsche Bank analyst Brian Skiba accompanied his buy rating with a $45 price target, but cautioned that investors should consider an investment in SCO "extremely high risk and volatile." Shares of SCO propelled $5.13, or 33%, to $20.66 in recent trading.

Buying SCO is akin to buying a call option on the company's controversial lawsuit against


(IBM) - Get Report

, Skiba wrote in his research note. In its suit filed in March, SCO charged IBM with misappropriating SCO's UNIX source code in its Linux business. But the case is complicated because of how SCO ended up with rights to Unix and the code's relationship to Linux.

As a "call option," an SCO investment would not be likely to expire before spring 2005, when the IBM case is scheduled to go to trial, Skiba wrote. In an interview, Skiba said he could not handicap the lawsuit but noted that most lawsuits settle before going to trial.

Accordingly, Skiba advised investors not to discount a potential takeout of SCO, particularly if the firm is able to slow down the adoption of Linux. SCO management has indicated $1 billion would be an acceptable takeout price -- about one-third of the $3 billion plus potential punitive damages SCO is seeking from IBM.

Although his buy rating was triggered by the legal case, Skiba calculated his $45 price target by forecasting earnings and revenue based on licensing agreements for Unix and other licensing opportunities. He estimated SCO could post earnings per share of $1 in calendar-year 2003 and $2.29 per share in 2004, leading to a forward price-earnings ratio of 20.

Skiba acknowledges that his call on SCO may be taken as heresy in the Linux community, but said it's important to separate the stock from the company. In addition, he argues that the idea of Linux being created by thousands of volunteer programmers is largely myth, given that companies like IBM,


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and others have paid thousands of employees to improve the operating system and build a business around it.

The largest risk is SCO Group's legal claims being without merit, Skiba wrote. "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," he wrote. In addition, SCO is being sued by Linux vendor

Red Hat


. Skiba has a hold rating on Red Hat. His firm hasn't done any investment banking with either Red Hat or SCO.

"This is not for widows and orphans," Skiba said of an investment in SCO. "Hedge funds would be a more appropriate market to buy this stock."

Hedge funds, however, may be on the other side. Currently, almost 12% of the stock's float is short, and the days to cover short interest went up to 5.13 on Sept. 15 from 4.51 on Aug. 15.

The only other analyst who covers SCO is Dion Cornett of Decatur Jones Equity Partners, according to Thomson First Call. He has an underperform rating on the stock.

Investing in SCO is like buying a "lottery ticket," Cornett said Wednesday. "I think at the end of the day, the lottery ticket is not a winner," he added. "They will not prevail in their lawsuit against IBM."

Cornett believes that IBM fights to the death when it believes it's right, as it clearly does here, and therefore a settlement is unlikely. Given the complicated intellectual property issues and David and Goliath tenor of the case, Cornett said, SCO could prevail in a jury trial.

But he believes Big Blue would win on appeal. "I think it's a stretch to think that an appellate court is going to overturn 100 years of copyright law," he said.

Cornett has a $6 price target on SCO, based on a discounted cash flow analysis. The company has not had a successful new product in four years, he said, and he is dubious of its effort to draw license revenue from Linux users fearful of being sued by SCO, as the company has suggested. So far, only


(MSFT) - Get Report


Sun Microsystems

(SUNW) - Get Report

and an undisclosed Fortune 500 company have signed such license deals.

Meanwhile, H-P's decision to

indemnify Linux customers has removed any incentive for H-P customers to sign up for SCO licenses. The next legal maneuver in the Linux battle may be SCO going after an H-P Linux customer in court to test the company's indemnification program.