WEBMETHODS INC - 10-Q Quarterly Report


[X]		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		FOR THE THREE MONTHS ENDED DECEMBER 31, 2002

		OR

[ ]		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

As of February 5, 2003, 51,656,796 shares of the registrant’s Common Stock, par value $.01 per share, were issued and outstanding.

WEBMETHODS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED DECEMBER 31, 2002
TABLE OF CONTENTS

WEBMETHODS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

The accompanying notes are an integral part of these condensed
consolidated financial statements.

WEBMETHODS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

The accompanying consolidated financial statements of webMethods, Inc. and its subsidiaries (collectively, the “Company”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended March 31, 2002. Certain information and footnote disclosures which are normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to SEC rules and regulations. The information reflects all normal and recurring adjustments, which, in the opinion of management, are necessary for a fair presentation of the financial position of the Company, and its results of operations for the interim periods set forth herein. The results for the three and nine months ended December 31, 2002 are not necessarily indicative of the results to be expected for the full year or any future period.

In July 2001, the Financial Accounting Standards Board issued SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives will be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but will rather be tested at least annually for impairment. Under the provisions of SFAS No. 142, any impairment loss identified upon adoption of this standard is recognized as a cumulative effect of a change in accounting principle. Any impairment loss incurred subsequent to initial adoption of SFAS No. 142 is recorded as a charge to current period earnings. In the event the Company acquires goodwill subsequent to June 30, 2001 it will not be amortized. The Company adopted SFAS No. 142 on April 1, 2002 and, at that time, stopped amortizing goodwill that resulted from business combinations completed prior to the adoption of SFAS No. 141.

The following table presents the impact of SFAS No. 142 on net loss and net loss per share had SFAS No. 142 been in effect for the quarter and nine months ended December 31, 2001 and 2002 (in thousands, except share and per share amounts):

There was no impairment recorded for the quarter and nine months ended December 31, 2002.

In June 2002, the Financial Accounting Standards Board issued SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities”. This standard is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of this standard is not expected to have a material effect on the Company’s financial position or results of operations.

In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, Accounting for Stock Based Compensation-Transition and Disclosure-an Amendment to FAS 123. SFAS 148 provides two additional transition methods for entities that adopt the preferable method of accounting for stock based compensation. Further, the statement requires disclosure of comparable information for all companies regardless of whether, when, or how an entity adopts the preferable, fair value based method of accounting. These disclosures are now required for interim periods in addition to the traditional annual disclosure. The amendments to SFAS No. 123, which provides for additional transition methods, are effective for periods beginning after December 15, 2002, although earlier application is permitted. The amendments to the disclosure requirements are required for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002.

In April 2002, the Company made an equity investment of approximately $1 million and a $1 million convertible debt investment in a third party, as a result of which the Company held, at December 31, 2002, an equity ownership position of less than 4% on a fully-diluted basis (excluding conversion of convertible notes). The Company recorded approximately $453,000 in royalty expenses for the quarter ended December 31, 2002 and approximately $794,000 for the nine months ended December 31, 2002 with this third party who shares a common Board member with the Company. In March 2002, the Company recorded an other-than-temporary decline in value of $200,000 in this equity investment. After that impairment charge, the Company had a remaining balance of $1.8 million in equity investment in this private company. There was no impairment of this investment recorded in the quarter ended December 31, 2002 or December 31, 2001.

In September 2002, the Company recorded an other-than-temporary decline in value of $1.0 million in another one of the equity investments the Company made in a private company during 2000. After that impairment charge, the Company had a remaining balance of $0 in equity investment in this private company.

The Company conducts operations worldwide and is primarily managed on a geographic basis with those geographic segments being the Americas, Europe and Asia Pacific region. Revenue is primarily attributable to the region in which the contract is signed and the product is deployed. Information regarding geographic areas is as follows (in thousands):

During the quarter ended September 30, 2001, the Company recorded a restructuring charge of $7.2 million, consisting of $2.5 million for headcount reductions, $4.0 million for consolidations of facilities, and $700,000 of other related restructuring charges. These restructuring charges were incurred to align the Company’s cost structure with changing market conditions. The restructuring plan resulted in a headcount reduction of approximately 150 employees or 14% of the workforce.

During the quarter ended December 31, 2002, the Company recorded a restructuring charge of $2.2 million due to a further headcount reduction of approximately 43 employees or 5% of the workforce. As of December 31, 2002 and March 31, 2002, respectively, $2.0 million and $3.0 million of restructuring charges remained unpaid. This unpaid portion primarily relates to rent on the excess facilities and will be paid over the remaining rental periods.

ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Readers are advised that this report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those indicated by the forward-looking statements. Statements using the words “believes,” “anticipates,” “plans,” “expects,” “intends,” “may,” “will,” “should,” “estimates,” “predicts,” “continue” and similar expressions are intended to identify forward-looking statements. Examples of forward-looking statements include, but are not limited to, (i) projections of revenue, costs or expense, margins, income or loss, earnings or loss per share, capital expenditures, cash requirements or other financial items and projections regarding the market for integration software, (ii) statements of the plans or objectives of the Company or its management, including the development or enhancement of software, development and continuation of strategic partnerships and alliances, implementation and effect of sales and marketing initiatives by the Company, focus on geographic or specific vertical markets and allocation of resources to them, predictions of the timing and type of customer or market reaction to those initiatives, the ability to control expenses, future hiring, the Company’s business

strategy and the execution of it, and actions by customers and competitors, (iii) statements of future economic performance or economic conditions and (iv) statements of assumptions underlying other statements or statements about the Company or its business.

This report also identifies important factors that could cause actual results to differ materially from those indicated by the forward-looking statements. These risks and uncertainties include those factors discussed in this Item under the caption “Factors that May Affect Future Operating Results.” Forward-looking statements are beyond the ability of the Company to control, and in many cases, the Company cannot predict what factors may cause actual results to differ from those indicated by the forward-looking statements. The Company disclaims any obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

We are a leading provider of software and services for comprehensive end-to-end integration solutions. We develop and deliver software products and provide related services that give large organizations the ability, seamlessly and in real-time, to integrate disparate information resources, to connect customers, vendors and business partners with the organization and its employees, to view and manage the connected information resources, data, business processes and human workflows and to provide Enterprise Web Services. By deploying the webMethods integration platform, customers can reduce costs, create new revenue opportunities, strengthen relationships with customers, vendors and business partners, substantially increase supply chain efficiencies and streamline internal business processes.

Our total revenue for the third quarter ended December 31, 2002 was $53.8 million, an increase of 10% compared to the quarter ended December 31, 2001. This increase in revenue was due primarily to the $3.5 million, or 12%, increase in license revenue and the $2.1 million, or 21%, increase in maintenance revenue, offset by the $901,000, or 10%, decrease in professional services revenue for the quarter. We decreased our net loss to $739,000 in the quarter ended December 31, 2002 from $13.9 million from the quarter ended December 31, 2001 primarily due to an increase in revenue of $4.7 million, a reduction in goodwill amortization of $8.9 million resulting from the adoption of SFAS No. 142 (see “Recently Issued Accounting Pronouncements”), a reduction of $1.4 million of amortization relating to deferred compensation costs and a reduction in other operating expenses, offset by a $2.2 million increase in restructuring costs.

License revenue increased by approximately $3.5 million, or 12%, to $33.9 million for the quarter ended December 31, 2002 from $30.4 million for the quarter ended December 31, 2001. Professional services revenue decreased by approximately $901,000, or 10%, to $8.0 million for the quarter ended December 31, 2002 from $8.9 million for the quarter ended December 31, 2001. This decrease in professional services revenue was due primarily to a decrease in our billable consultants and, to a lesser extent, an increase in the self-sufficiency of our customers to do their own implementations and an increase in systems integrator led customer implementations. Maintenance revenue increased by approximately $2.1 million, or 21%, to $11.9 million for the quarter ended December 31, 2002 from $9.8 million for the quarter ended December 31, 2001. This increase is due primarily to the increase in customers purchasing our software and related maintenance contracts.

We have continued to focus on cost management while continuing to expand and service our customer base. While our total revenues increased by 10% during the quarter ended December 31, 2002, as compared to the quarter ended December 31, 2001, our operating expenses were lower in the same period. The increase in revenue and the decrease in expenses resulted in an improvement in operating loss and net loss for the quarter ended December 31, 2002.

We continue to sell our integration platform to Global 2000 customers through our direct sales force augmented by system integrators, through our relationships with application software partners and internationally through resellers and distributors. We license our software to customers primarily on a

perpetual basis and to a lesser extent on a renewable basis. As of December 31, 2002, we had over 900 customers. Existing customers accounted for more than 50% of our license revenue in the quarter ended December 31, 2002 as a result of their expanded use of our software. No customer accounted for more than 10% of our total revenue in the quarters ended December 31, 2002 and 2001.

We continue to believe one of our competitive differentiators is our strong partnerships with application software companies and system integrators. Under our partnerships with application software vendors, which include i2 Technologies, J.D. Edwards, SAP AG and Siebel Systems, the partner may resell or embed our software with their applications under limited use licenses for a license or royalty fee. Our application and system integrator partners actively assist us in selling the full webMethods integration platform to their customers, making us the logical choice for enterprise-wide integration initiatives. Under certain partnership arrangements, we may share license fees derived from joint selling opportunities with our partners. In other partnership arrangements, we may pay a sales assistance fee to a partner who performs or assists in certain sales activities, and that fee usually is paid once the license fee payment from the joint customer is received. We believe our partners influenced, directly or indirectly, a substantial portion of our license revenue during the quarter ended December 31, 2002.

Our focus on customer success and satisfaction has resulted in an increasing number of referenceable customers, and a substantial portion of our license revenue in the quarter ended December 31, 2002 came from our existing customers. We strive to provide the most comprehensive integration platform available, and will continue to invest as we strive to achieve an advantageous positioning relative to our competition resulting in recognized industry and technology leadership and increasing market share.

During the quarter ended September 30, 2002, we began shipping webMethods Manager and webMethods 6, the next-generation of our comprehensive integration platform. webMethods 6 is a standards-based, massively scalable integration platform designed to be the foundation for next generation integration suites, and is built on a fully service-oriented architecture so that customers can leverage integration and Web services more widely and flexibly across their enterprise and assemble solutions that meet their specific needs. During the quarter ended March 31, 2002, we introduced and began shipping our Workflow product, which provides powerful workflow capabilities enabling non-programmers to model, prototype and deploy sophisticated human workflows within a business process without any coding.

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures. We evaluate our estimates, on an on-going basis, including those related to allowances for bad debts, investments, intangible assets, income taxes, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ for these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

We enter into arrangements, which may include the sale of licenses of our software, professional services and maintenance or various combinations of each element. We recognize revenue based on Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended and modified by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” SOP 98-9 modified SOP 97-2 by requiring revenue to be recognized using the “residual method” if certain conditions are met. Revenue is recognized based on the residual method when an agreement has been signed by both parties, the fees are fixed or determinable, collection of the fees is probable, delivery of the

product has occurred, vendor specific objective evidence of fair value exists for any undelivered element, and no other significant obligations remain. Revenue allocated to the undelivered elements is deferred using vendor-specific objective evidence of fair value of the elements and the remaining portion of the fee is allocated to the delivered elements (generally the software license).

Policies related to revenue recognition require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. These sources may publish new authoritative guidance, which might impact our current revenue recognition policy. We continue to evaluate our revenue recognition policy as new authoritative interpretations and guidance are published, and where appropriate, may modify our revenue recognition policy. Application of our revenue recognition policy requires a review of our license and professional services agreements with customers and may require management to exercise judgment in evaluating, among other things, whether delivery has occurred, payments are fixed and determinable, collection is probable, and where applicable, if vendor-specific objective evidence of fair value exists for undelivered elements of the contract. In the event judgment in the application of our revenue recognition policy is incorrect, the revenue recognized by us could be impacted.

We maintain allowances for doubtful accounts for estimated losses, which may result from the inability of our customers to make required payments to us. These allowances are established through analysis of the creditworthiness of customers and collectability of receivables by using information such as credit reports from third parties, published or publicly available financial information, customer specific experience including payment practices and history, inquiries, and other financial information from our customers. The use of different estimates or assumptions could produce materially different allowance balances. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

We record an investment impairment charge when we believe an investment in corporate debt securities or in equity securities of private companies has declined in value and that such a decline is other than temporary. The determination of the value of the investments is based on information provided to us from the private companies such as audited financial statements, valuations based on recent sales of equity, projections, representations by management, and third party valuations if available. Future adverse changes in market conditions or poor operating results of the underlying companies could result in losses or a perceived inability to recover the carrying value of the investments that may not be reflected in an investment’s current carrying value, thereby possibly requiring an impairment charge in the future. As of December 31, 2002, we had a remaining balance of $1.8 million in private company equity investments.

Under SFAS No. 142, which we adopted on April 1, 2002, all of our goodwill will be associated with our corporate reporting unit as we do not have multiple reporting units. On an annual basis we will evaluate whether an impairment of the goodwill may exist by comparing the book value of our outstanding common stock to the market value of our outstanding common stock. If the market value exceeds the book value, impairment does not exist. If the market value is less than the book value, we will evaluate whether the condition is other than temporary based primarily on fluctuations in our stock price. If we determine that the condition is other than temporary, we will record an impairment equal to the excess book value. See “Recently Issued Accounting Pronouncements,” for more information.

The functional currency for our foreign operations is the local currency. The financial statements of foreign subsidiaries have been translated into United States dollars. Asset and liability accounts have been translated using the exchange rate in effect at the balance sheet date. Revenue and expense accounts have been translated using the average exchange rate for the period. The gains and losses associated with the translation of the financial statements resulting from the changes in exchange rates from period to period

have been reported in other comprehensive income or loss. To the extent assets and liabilities of the foreign operations are realized or the foreign operations are expected to pay back the intercompany debt in the foreseeable future, amounts previously reported in other comprehensive income or loss would be included in net income or loss in the period in which the transaction occurs. Transaction gains or losses, other than intercompany debt deemed to be of a long-term nature, are included in net income or loss in the period in which they occur.

We have recorded a tax valuation allowance to reduce our deferred tax assets to the amount that is expected to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax asset in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

The following table summarizes the results of our operations for the quarter and nine months ended December 31, 2002 compared with the quarter and nine months ended December 31, 2001 (in thousands):

Total revenue increased by approximately $2.4 million, or 2%, to $147.6 million for the nine months ended December 31, 2002 from $145.2 million for the nine months ended December 31, 2001. This increase is primarily attributable to an increase in sales to new and existing customers. During the quarter ended December 31, 2002, total revenue increased approximately $4.7 million, or 10%, to $53.8 million from $49.1 million for the quarter ended December 31, 2001. The increase was principally due to increased license revenue and maintenance revenue offset by a decrease in professional services revenue.

Our net loss of $8.7 million for the nine months ended December 31, 2002 decreased by approximately $58.2 million, or 87%, from the nine months ended December 31, 2001. During the quarter ended December 31, 2002, our net loss decreased by approximately $13.1 million, or 95%, to $739,000 from $13.8 million for the quarter ended December 31, 2001. The decrease in net loss for the quarter and nine months ended December 31, 2002 was primarily due to a reduction in goodwill amortization, amortization of deferred compensation costs and a decrease in other operating expenses. The decrease in net loss for the nine months ended December 31, 2002 was also impacted by a reduction in restructuring charges.

The following table summarizes the Company’s revenue for the quarter and nine months ended December 31, 2002 compared with the quarter and nine months ended December 31, 2001 (in thousands):

Total revenue increased by approximately 2% for the nine months ended December 31, 2002 compared to the nine months ended December 31, 2001. The increase in license and maintenance revenue during the nine month period was substantially offset by a decrease in professional services revenue. During the quarter ended December 31, 2002, total revenue increased 10% compared to the quarter ended December 31, 2001 due to an increase in license and maintenance revenue, which was partially offset by a decrease in professional services revenue. License revenue for the quarter ended December 31, 2002 was positively affected by an increase in the number of larger deals as well as the introduction of new products such as webMethods Workflow, webMethods Manager, and webMethods 6.

For the nine months ended December 31, 2002, license revenue remained relatively flat at $89.0 million as compared to the nine months ended December 31, 2001. License revenue increased by approximately $3.5 million, or 12%, to $33.9 million in the quarter ended December 31, 2002 from $30.4 million in the quarter ended December 31, 2001. This increase is primarily attributable to an increase in sales to new and existing customers. License revenue increased in both Americas and Europe and decreased in Asia Pacific during the quarter ended December 31, 2002 as compared to the quarter ended December 31, 2001.

For the nine months ended December 31, 2002, professional services revenue decreased by approximately $3.2 million, or 11%, to $24.7 million from $27.9 million for the nine months ended December 31, 2001. For the quarter ended December 31, 2002, professional services revenue decreased by approximately $901,000, or 10%, to $8.0 million from $8.9 million for the quarter ended December 31, 2001. This decrease in professional services revenue was due to a decrease in billable consultants, the increase in system integrator led customer implementations, and, to a lesser extent, an increase in the self-sufficiency of existing customers to expand the deployment of our products.

For the nine months ended December 31, 2002, maintenance revenue increased by approximately $5.5 million, or 19%, to $33.8 million from $28.3 million for the nine months ended December 31, 2001. For the quarter ended December 31, 2002, maintenance revenue increased by approximately $2.1 million, or 21%, to $11.9 million from $9.8 million for the quarter ended December 31, 2001. This increase is due primarily to the increase in customers purchasing our software and related maintenance contracts.

The following table summarizes the Company’s net revenue by geographic region for the quarter and nine months ended December 31, 2002 compared with the quarter and nine months ended December 31, 2001 (in thousands):

For the nine months ended December 31, 2002, revenue from the Americas decreased by approximately $3.3 million, or 3%, to $102.1 million from $105.4 million for the nine months ended December 31, 2001. We believe this decrease was due primarily to the continued economic slowdown and the decline in technology spending. For the quarter ended December 31, 2002, revenue from the Americas increased approximately $3.7 million, or 11%, to $38.8 million from $35.1 million for the quarter ended December 31, 2001. Increases in Americas’ license and maintenance revenue during the quarter ended December 31, 2002 were offset by a decline in professional services revenue.

For the quarter and nine month periods ended December 31, 2002, combined revenue from Europe and Asia Pacific (“international revenue”) increased by approximately $979,000, or 7%, and approximately $5.7 million, or 14%, to $15.0 million and $45.5 million, respectively, as compared to the quarter and nine months ended December 31, 2001. International revenue accounted for 28% and 31% of our total revenue for the quarter and nine months ended December 31, 2002 as compared to 28% and 27% for the quarter and nine months ended December 31, 2001. The increases in international revenue were principally due to our increased focus and investments in the Asia Pacific region, an increased acceptance of our software in this region and larger deal sizes.

The following table summarizes the Company’s gross profit by type of revenue, excluding stock based compensation, for the quarter and nine months ended December 31, 2002 compared with the quarter and nine months ended December 31, 2001:

We improved our total gross margin, excluding stock based compensation, to 78% for the nine months ended December 31, 2002 from 76% for the nine months ended December 31, 2001. For the quarter ending December 31, 2002, we improved our total gross margin, excluding stock based compensation, to 79% from 78% for the quarter ending December 31, 2001.

Our cost of license revenue, excluding stock based compensation, consists of royalties for products licensed from third parties. Our gross profit on license revenue, excluding stock based compensation, was 98% for the quarters and nine months ended December 31, 2002 and 2001, respectively.

Our cost of professional services and maintenance, excluding stock based compensation, consists of costs related to internal professional services and support personnel, and subcontractors hired to provide implementation and support services. Our gross margin on maintenance and services, excluding stock based compensation, was 46% and 42%, respectively, for the nine months ended December 2002 and 2001 and 48% and 46%, respectively, for the quarters ended December 31, 2002 and 2001. The nine month and quarterly improvement in these margins is due primarily to lower costs of professional services due to a decrease in our number of professional services personnel and reduced use of subcontractors.

The following table presents certain information regarding the Company’s operating expenses during the quarter and nine months ended December 31, 2002 compared with the quarter and nine months ended December 31, 2001 (in thousands):

Our operating expenses are primarily classified as sales and marketing, research and development and general and administrative. Each category includes related expenses for compensation, employee benefits, professional fees, travel, communications and allocated facilities, recruitment and overhead costs. Our sales and marketing expenses also include expenses which are specific to the sales and marketing activities, such as commissions, trade shows, public relations, business development costs, promotional costs and marketing collateral. Also included in our operating expenses is the amortization of deferred stock compensation, restructuring charges, and, during 2001, amortization of goodwill and intangibles. Our sales and marketing expenses also include amortization of a warrant charge.

In July 2001, we took decisive actions to reduce our operating expenses to realign our cost structure to address the changing market conditions caused by the slowing of the global economy and technology spending. As part of this action, we reduced our headcount by 14% or 150 employees through a reduction in force, closed excess sales offices and consolidated our California facilities into two locations. The headcount reductions were across all departments with the exception of customer support. During the

quarter ended December 31, 2002, the Company further reduced its headcount by 5% or an additional 43 employees.

Sales and marketing expenses, excluding stock based compensation and warrant charge, decreased by approximately $9.2 million, or 11%, to $71.2 million for the nine months ended December 31, 2002 from $80.4 for the nine months ended December 31, 2001 and represented 48% and 55% of total revenue, respectively. This decrease was primarily due to sales and marketing headcount reductions which were done in July of 2001. During the quarter ended December 31, 2002, sales and marketing expense, excluding stock based compensation and warrant charge, decreased approximately $1.8 million, or 7% to $24.3 million from $26.1 million for the quarter ended December 31, 2001 and represented 45% and 53% of total revenue respectively. This decrease was primarily due to lower sales and marketing personnel costs, a reduction in sales assistance fees, and a decrease in recruiting fees. These decreases were offset by an increase in marketing trade show activity, particularly our annual Integration World event in October 2002.

Research and development expenses, excluding stock based compensation, decreased by approximately $1.5 million, or 4% to $36.1 million for the nine months ended December 31, 2002 from $37.6 million for the nine months ended December 31, 2001 and represented 24% and 26% of total revenue, respectively. This decrease is primarily due to reduced headcount associated with the July 2001 restructuring. During the quarter ended December 31, 2002, research and development expenses, excluding stock based compensation, decreased approximately $160,000, or 1% to $12.0 million from $12.2 million for the quarter ended December 31, 2001 and represented 22% and 25% of total revenues, respectively. This decrease was primarily due to decreases in contractor expenses and travel, offset by increases in personnel costs.

General and administrative expenses, excluding stock based compensation, decreased by approximately $2.1 million, or 14% to $13.1 million for the nine months ended December 31, 2002 from $15.2 million for the nine months ended December 31, 2001 and represented 9% and 10% of total revenue, respectively. This decrease was primarily due to reduced headcount associated with the July 2001 restructuring. During the quarter ended December 31, 2002, general and administrative expenses, excluding stock based compensation, increased approximately $185,000, or 4% to $4.8 million from $4.6 million for the quarter ended December 31, 2001 and both represented 9% of total revenue. This increase was primarily attributable to an increase in personnel costs and insurance expense.

Stock based compensation and warrant charge were $3.2 million and $14.7 million during the nine months ended December 31, 2002 and 2001, respectively, of which $218,000 and $368,000, respectively, was included in cost of sales. During the quarters ended December 31, 2002 and 2001, stock based compensation and warrant charge were $987,000 and $2.4 million, respectively, of which $65,000 and $47,000 was included in cost of sales. Deferred stock based compensation and warrant charge were recorded for the following transactions:

(i) In connection with the grant of stock options to employees and non-employee directors during the quarters ended June 30, 2000 and 1999, we recorded aggregate unearned compensation of $15.5 million, representing the difference between the deemed fair value of our common stock at the date of grant and the exercise price of such options.

(ii) As a result of the acquisitions of Translink Software, Inc., Premier Software Technology, Inc. and Alier, Inc., we recorded a deferred stock compensation charge of $27.9 million related to restricted stock issued to stockholders of the acquired companies.

(iii) In June 2001 we entered into an OEM/Reseller agreement with i2 Technologies (i2) and issued a warrant, which, as amended, permits i2 to purchase 710,000 shares of our common stock at an exercise price of $28.70 per share. The fair value of the warrant, based on the Black-Scholes valuation model, was $23.6 million on the date of issuance which has been recorded as a deferred warrant charge. As part of the agreement, i2 will pay us OEM fees of $10.0 million over the term of the OEM/Reseller agreement which will be recorded as a reduction to the deferred warrant charge and will not be recorded as revenue.

The deferred stock compensation and warrant charge is presented as a reduction of stockholders’ equity and is amortized over the vesting period of the applicable equity arrangement and is shown by expense category.

We recorded goodwill and intangible assets in connection with the acquisition of Premier and Translink in fiscal 2001 and Alier in fiscal 2000. The estimated useful life of the goodwill and the acquired intangibles during the quarter ended December 31, 2001 was three years for trained and acquired assembled workforce, one year for license agreements, two years for non-compete agreements, three years for goodwill and four years for favorable lease terms. We recorded $8.9 million of amortization of goodwill and acquired intangibles in the quarter ended December 31, 2001. Amortization of the goodwill and acquired intangibles ceased on April 1, 2002 upon our adoption of SFAS No. 142 (see “Recently Issued Accounting Pronouncements” for more information).

Net interest income decreased by approximately $4.0 million, or 55%, to $3.2 million for the nine months ended December 31, 2002 from $7.2 million for the nine months ended December 31, 2001. During the quarter ended December 31, 2002, net interest income decreased $807,000, or 45%, to $975,000 from $1.8 million for the quarter ended December 31, 2001. These decreases were primarily attributable to our lower average cash balance as well as lower interest rates on corporate paper, bonds and money market funds in the respective period of fiscal 2003, compared to those in the same period in the prior year.

We have recorded a valuation allowance for the full amount of our net deferred tax assets, as the realizability of the deferred tax assets is not currently predictable.

The following table presents selected financial statistics and information as of December 31, 2002 compared to March 31, 2002:

Historically we have financed our operations and met our capital requirements through our revenue and the sales of equity securities. Our liquidity and financial position at December 31, 2002, showed a 6% decrease in our cash and investments and a 9% decrease in our working capital from our positions at March 31, 2002. The decrease in working capital is primarily due to a decrease in cash and cash equivalents, offset by decreases in accounts payable, and a decrease in accrued salaries and commissions at December 31, 2002, as compared to December 31, 2001.

Net cash used in operating activities was $13.5 million during the nine months ended December 31, 2002, and as compared to $718,000 provided by operating activities during the nine months ended December 31, 2001. The increase in net cash used in operating activities from 2001 to 2002 was due primarily to larger decreases in our accounts payable, accrued expenses and accrued salaries and commissions for the nine months ended December 31, 2002 compared to the nine months ended December 31, 2001.

Net cash used in investing activities during the nine months ended December 31, 2002 and 2001, was $15.0 million and $45.5 million, respectively. This was primarily due to the purchase of marketable securities and, to a lesser extent, to the purchase of property and equipment. Capital expenditures were $2.5 million and $4.6 million during the nine months ended December 31, 2002 and 2001, respectively.

Capital expenditures consisted of purchases of operating resources to manage operations, including computer hardware and software, office furniture and equipment and leasehold improvements. We generally fund capital expenditures either through capital leases or the use of working capital. Net cash used in investing activities was offset by the sale of an investment in a private company during the nine months ended December 31, 2001.

Net cash provided by financing activities was $3.2 million and $6.2 million during the nine months ended December 31, 2002 and 2001, respectively. These cash flows primarily reflect net cash proceeds from exercises of stock option and employee stock purchase plan purchases during the respective periods and borrowings under lease agreements during the nine months ended December 31, 2002.

We believe that our existing working capital and our line of credit will be sufficient to meet our working capital and operating resource expenditure requirements for at least the next twenty-four months. However, we may utilize cash resources to fund acquisitions or investments in complementary businesses, technologies or product lines. In the event additional financing is required, we may not be able to raise it on acceptable terms or at all.

You should consider the following factors when evaluating our statements in this report and elsewhere. webMethods is subject to risks in addition to those described below, which, at the date of this report, we may not be aware of or which we may not consider significant. Those risks may adversely affect our business, financial condition, results of operations or the market price of webMethods’ stock.

Unanticipated fluctuations in our quarterly revenue or operating results could affect the price of our stock.

We believe that quarter-to-quarter or year-to-year comparisons of our financial results are not necessarily meaningful indicators of our future revenue or operating results and should not be relied on as an indication of our future performance. If our quarterly or annual revenue or operating results fail to meet the expectations of investors or analysts, the market price of webMethods’ stock could be negatively affected. Our quarterly operating results have varied substantially in the past and may vary substantially in the future depending upon a number of factors, including the changes in demand for our products and services, economic conditions, competitive pressures, amount and timing of operating costs and changes that we may make in our business, operations and infrastructure. In addition, uncertainties and economic after-effects of terrorist acts or other major, unanticipated events may impact our quarterly operating results. In our fiscal 2002 and the first three quarters of fiscal year 2003, we closed a substantial number of license transactions in the last month of each quarter, which makes it more difficult to gauge the level of license revenue we will have in any quarter until near to, or after, its conclusion. We expect to continue devoting resources to our sales and marketing operations and our research and development activities. Our operating expenses, which include sales and marketing, research and development and general and administrative expenses, are based on our expectations of future revenue and are relatively fixed in the short term. If revenue falls below our expectations in a quarter and we are not able to quickly reduce our spending in response, our operating results for that quarter could be significantly below the expectations of investors or analysts. It is possible that our revenue or operating results in the future may be below the expectations of investors or analysts and, as a result, the market price of webMethods’ stock may fall. In addition, the stock market, particularly the stock prices of independent infrastructure software companies, has been very volatile. This volatility is often not related to the operating performance of the companies. From our initial public offering in February 2000 until February 1, 2003, the closing price of webMethods’ stock on NASDAQ has ranged from a high of $336.25 to a low of $4.32.

Growth of our sales may slow from time to time, causing our quarterly operating results to fluctuate.

Due to customer demand, economic conditions, competitive pressures or seasonal factors, we may experience a lower growth rate for, no growth in, or a decline in quarterly or annual revenue from sales of

our software and services. For example, the growth rate for revenue from sales of our software and services during summer months may be slower than at other times during year, particularly in European markets.

We also may experience declines in expected revenue due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers, changes in demand for our software and services and deferrals of purchases due to uncertainties and economic after-effects of terrorist acts, geopolitical developments or uncertainties or other major, unanticipated events. These periods of slower or no growth may lead to lower revenue, which could cause fluctuations in our quarterly operating results. In addition, variations in sales cycles may have an impact on the timing of our revenue, which in turn could cause our quarterly operating results to fluctuate. To successfully sell our software and services, we generally must educate our potential customers regarding their use and benefits, which can require significant time and resources. Any delay in sales of our software and services could cause our revenue and operating results to vary significantly from quarter to quarter, which could result in volatility in the market price of webMethods’ stock.

The integration software and web services markets are highly competitive, and we may not be able to compete effectively.

The market for integration software solutions and technology to implement enterprise web services is rapidly changing and intensely competitive. There are a variety of methods available to integrate software applications and to implement web services. We expect that competition will remain intense as the number of entrants and new technologies increases. We do not know if our target markets will widely adopt and deploy integration products such as our software. If our software and enterprise web services are not widely adopted by our target markets or if we are not able to compete successfully against current or future competitors, our business, operating results and financial condition may be harmed. Our current and potential competitors include, among others, large software vendors, companies and trading exchanges that develop their own integration and web service solutions, electronic data interchange, or EDI, vendors, vendors of proprietary enterprise application integration (EAI) solutions and application server vendors. We also face competition from various providers of application integration solutions technologies to implement web services and companies offering products and services that address specific aspects of application integration or web services integration. Further, we face competition for some aspects of our software and service offerings from major system integrators, both independently and in conjunction with corporate in-house information technology departments, which have traditionally been the prevalent resource for application integration. In addition, our customers and companies with whom we currently have strategic relationships may become competitors in the future. Some of our competitors or potential competitors may have more experience developing integration software or implementing web services, larger technical staffs, larger customer bases, more established distribution channels, greater brand recognition and greater financial, marketing and other resources than we do. Our competitors may be able to develop products and services that are superior to our software and services, that achieve greater customer acceptance or that have significantly improved functionality or performance as compared to our existing software and future software and services. In addition, negotiating and maintaining favorable customer and strategic relationships is critical to our business. Our competitors may be able to negotiate strategic relationships on more favorable terms than we are able to negotiate. Many of our competitors may also have well-established relationships with our existing and prospective customers. Increased competition may result in reduced margins, loss of sales or decreased market share, which in turn could harm our business, operating results and financial condition.

We rely on strategic partnerships with software vendors, alliances with major system integrators and other similar relationships to implement and promote our software and, if these relationships terminate, we may lose important deals and marketing opportunities.

We have established strategic relationships with enterprise application software vendors and system integration partners. These strategic partners provide us with important sales and marketing opportunities, create opportunities to upsell our products to customers already using our software embedded in their enterprise application products, and greatly increase our implementation capabilities. We also have similar relationships with resellers, distributors and other technology leaders. If our relationships with any of these organizations were terminated or if we failed to work effectively with our partners or to grow our base of

strategic partners, resellers and distributors, we might lose important opportunities, including sales and marketing opportunities, and our business may suffer. In general, our partners are not required to market or promote our software and generally are not restricted from working with competing integration software companies. Accordingly, our success will depend on their willingness and ability to devote sufficient resources and efforts to marketing our software rather than the products of competitors. If these relationships are not successful or if they terminate, our revenue and operating results could be materially adversely affected, our ability to increase our penetration of the market for integration software could be impaired, we may have to devote substantially more resources to the distribution, sales and marketing, implementation and support of our software than we would otherwise, and our efforts may not be as effective as those of our partners, which would harm our business.

We are trying to increase our sales to the US Government and to others in the public sector, and we may face difficulties in our attempts to procure new contracts with them.

We are attempting to expand our customer base to include more entities and agencies within the US Government and state and local governments. Developing new business in the public sector often requires companies to develop relationships with different agencies or entities, as well as other government contractors. If we are unable to develop or sustain these relationships, we may be unable to procure new contracts within the timeframe we expect, and our business and financial results may be adversely affected. Contracting with the US Government also requires businesses to participate in a highly competitive bidding process to obtain new contracts. We are a young company, and we lack substantial experience in bidding for public sector contracts. We may be unable to bid competitively if our software and services are improperly priced or if we are incapable of providing our software and services at a competitive price. The bidding process is an expensive and time-consuming endeavor that may result in a loss for webMethods if we fail to win a contract on which we submitted a bid. Furthermore, some agencies within the US Government may also require some or all of our personnel to obtain a security clearance. If our key personnel are unable to obtain or retain this clearance, we may be unsuccessful in our bid for some government contracts. The US Government may choose to change the way it procures new contracts, and it may adopt new rules or regulations governing contracts such as cost accounting standards. If these changes were implemented, they could cause our costs to increase and may make it difficult or impossible for us to obtain new contracts or keep any existing contracts when they expire or are subject to renewal.

Third party claims that we infringe upon their intellectual property rights could be costly to defend or settle or could damage our business.

We cannot be certain that our software and the services do not infringe issued patents, copyrights or other intellectual property rights of third parties. Litigation regarding intellectual property rights is common in the software industry, and we may be increasingly subject to legal proceedings and claims from time to time, including claims of alleged infringement of intellectual property rights of third parties by us or our licensees concerning their use of our software products and integration technologies and services. Although we believe that our intellectual property rights are sufficient to allow us to market our software without incurring liability to third parties, third parties may bring claims of infringement against us. Such claims may be with or without merit. Claims of alleged infringement may have a material adverse effect on our business and may discourage potential customers from doing business with us on acceptable terms, if at all. Litigation to defend against claims of infringement or contests of validity could be very time-consuming and could result in substantial costs and diversion of resources, including our management’s attention to our business. Furthermore, a party making such a claim could secure a judgment that requires us to pay substantial damages. A judgment could also include an injunction or other court order that could prevent us from selling our software. Our business, operating results and financial condition could be harmed significantly if any of these events occurred, and the price of webMethods common stock could be adversely affected. Furthermore, former employers of our current and future employees may assert that our employees have improperly disclosed confidential or proprietary information to us. In addition, we have agreed, and may agree in the future, to indemnify certain of our customers against claims that our software infringes upon the intellectual property rights of others. We could incur substantial costs in defending ourself and our customers against infringement claims. In the event of a claim of infringement, we, as well as our customers, may be required to obtain one or more licenses from third parties, which may not be

available on acceptable terms, if at all. Defense of any lawsuit or failure to obtain any such required licenses could harm our business, operating results and financial condition and the price of webMethods common stock.

Contracting with the US Government or state and local governments is very different from contracting in the private sector, and these differences could have a detrimental effect on our operating results.

Contracts with the US Government or with many state and local governments frequently include provisions not found in the private sector and are often governed by laws and regulations that do not affect private contracts. These differences permit the public sector customer to take action not available to customers in the private sector. This may include termination of current contracts for convenience or due to a default. If a public sector customer cancels a contract for convenience, which can occur if need for a product changes, we may only be able to collect costs for work done prior to the termination of the contract. If the public sector customer cancels because of default, we may only be able to collect revenue for work we have completed, and we may be forced to pay any costs the public sector customer incurs for procuring the promised product from another source. The US Government can also suspend operations if Congress does not allocate sufficient funds, and the US Government may allow our competitors to protest our successful bids. The US Government also may ban webMethods from doing business with any government entity, and could also impose fines, levy sanctions or subject us to a criminal prosecution. The US Government may refuse to invoke an option to extend a contract and it could attempt to claim rights in technologies and systems we invent. Some government agencies we contract with may prohibit us from seeking contracts with certain other government agencies. If any of these events occur, they may negatively affect our business and financial results. In order to maintain contracts with the US Government, webMethods must also comply with many rules and regulations that may affect our relationship with other customers. The US Government can terminate its contract with us if we come under foreign government control or influence, may require that we disclose our pricing data during the course of negotiations, and may require us to prevent access to classified data. If the US Government requires us to meet any of these demands, it could result in increased costs or an inability to take advantage of certain opportunities that may present themselves in the future. US Government agencies routinely investigate and audit government contractors’ administrative processes. They may audit our performance and our pricing, and review our compliance with rules and regulations. If they find that we have improperly allocated costs, they may require us to refund those costs or may refuse to pay us for outstanding balances related to the improper allocation. An unfavorable audit could result in a reduction of revenue, and may result in civil or criminal liability if the audit uncovers improper or illegal activities. This could harm our business, financial results and reputation.

Our operating results may decline and our customers may become dissatisfied if we do not provide professional services or if we are unable to establish and maintain relationships with third-party implementation providers.

Customers that license our software typically engage our professional services staff or third party consultants to assist with support, training, consulting and implementation. We believe that many of our software sales depend, in part, on our ability to provide our customers with these services and to attract and educate third-party consultants to provide similar services. New professional services personnel and service providers require training and education and take time to reach full productivity, and competition for qualified personnel and service providers is intense. Our business may be harmed if we are unable to provide professional services to our customers and establish and maintain relationships with third-party implementation providers.

Our software must integrate with applications made by third parties, and, if we lose access to the programming interfaces for these applications, or if we are unable to modify our software or develop new adapters in response to changes in these applications, our business could suffer.

Our software uses software components called adapters to communicate with our customers’ enterprise applications. Our ability to develop these adapters is largely dependent on our ability to gain access to the application programming interfaces, or APIs, for the applications, and we may not have access to necessary APIs in the future. APIs are written and controlled by the application provider. Accordingly, if an

application provider becomes a competitor by entering the integration market, it could restrict access to its APIs for competitive reasons. Our business could suffer if we are unable to gain access to these APIs. Furthermore, we may need to modify our software or develop new adapters in the future as new applications or newer versions of existing applications are introduced. If we fail to continue to develop adapters or respond to new applications or newer versions of existing applications, our business could suffer. We rely in part on third parties to develop adapters necessary for the integration of applications using our software. We cannot be certain that these companies will continue to develop these adapters, or that, if they do not continue to do so, that we will be able to develop these adapters internally in a timely or efficient manner. In addition, we cannot be certain that adapters developed by third parties will not contain undetected errors or defects, which could harm our reputation, result in product liability or decrease the market acceptance of our products.

Our executive officers and certain key personnel are critical to our business, and these officers and key personnel may not always remain with us.

Our success depends upon the continued service of our executive officers and other key employees, and none of these officers or key employees is bound by an employment agreement for any specific term. If we lose the services of one or more of our executive officers or key employees, or if one or more of them decide to join a competitor or otherwise compete directly or indirectly with us, our business, operating results and financial condition could be harmed. In particular, Phillip Merrick, our Chairman of the Board and Chief Executive Officer, David Mitchell, our President and Chief Operating Officer, R. James Green, our Chief Technology Officer and Executive Vice President, and Mary Dridi, our Chief Financial Officer and Executive Vice President, would be particularly difficult to replace. Our future success will also depend in large part on our ability to attract and retain experienced technical, sales, marketing and management personnel.

If our customers do not renew their product support and maintenance agreements, we may lose a recurring revenue stream, which could harm our operating results.

Many of our customers subscribe for software support and maintenance services, which we recognize over the term of those support and maintenance agreements. If a significant portion of those customers chose not to continue subscribing for product support and maintenance, our recurring revenue from those services would be adversely affected, which could harm our business, operating results and financial condition.

We may not be able to increase market awareness and sales of our software if we do not maintain our sales and distribution capabilities.

We need to maintain and further develop our direct and indirect sales and distribution efforts, both domestically and internationally, in order to increase market awareness and sales of our software and the related services we offer. Our software requires a sophisticated sales effort targeted at multiple departments within an organization. Competition for qualified sales and marketing personnel is intense, and we might not be able to hire and retain adequate numbers of such personnel. Our competitors have attempted to hire employees away from us, and we expect that they will continue such attempts in the future. We also plan to expand our relationships with system integrators, enterprise software vendors and other third-party resellers to further develop our indirect sales channel. As we continue to develop our indirect sales channel, we will need to manage potential conflicts between our direct sales force and third party reselling efforts, which may impact our business and operating results.

We intend to continue expanding our international sales efforts, and our inability to do so could harm our business and operating results.

We have been, and intend to continue, expanding our international sales efforts. We have limited experience in marketing, selling and supporting our software and services abroad. Expansion of our international operations will require a significant amount of attention from our management and substantial financial resources. If we are unable to continue expanding our international operations successfully and in a timely manner, our business and operating results could be harmed. In addition, doing business

internationally involves additional risks, particularly: the difficulties and costs of staffing and managing foreign operations; unexpected changes in regulatory requirements, taxes, trade laws and tariffs; differing intellectual property rights; differing labor regulations; and changes in a specific country’s or region’s political or economic conditions.

If we experience delays in developing our software, or if our software contains defects, we could lose customers and revenue.

We expect that the rapid evolution of integration software and standards and web services technologies and protocols, as well as general technology trends such as changes in or introductions of operating systems or enterprise applications, will require us to adapt our software to remain competitive. Our software could become obsolete, unmarketable or less desirable to prospective customers if we are unable to adapt to new technologies or standards. Software as complex as ours often contains known and undetected errors or performance problems. Many serious defects are frequently found during the period immediately following introduction of new software or enhancements to existing software. Internal quality assurance testing and customer testing may reveal product performance issues or desirable feature enhancements that could lead us to postpone the release of new versions of our software. The reallocation of resources associated with any postponement could cause delays in the development and release of future enhancements to our currently available software and could damage the reputation of our software in the marketplace. Although we attempt to resolve all errors that we believe would be considered serious by our customers, our software is not error-free. Undetected errors or performance problems may be discovered in the future, and known errors that we consider minor may be considered serious by our customers. This could result in lost revenue or delays in customer deployment and would be detrimental to our reputation, which could harm our business, operating results and financial condition. If our software experiences performance problems, we may have to increase our product development costs and divert our product development resources to address the problems. In addition, because our customers depend on our software for their critical systems and business functions, any interruptions could cause our customers to initiate product liability suits against us.

Because our software could interfere with the operations of our customers’ other software applications, we may be subject to potential product liability and warranty claims by these customers, which may be time consuming, costly to defend and may not be adequately covered by insurance.

Our software is integrated with our customers’ networks and software applications and is often used for mission critical applications. Errors, defects or other performance problems could result in financial or other damages to our customers. Customers could seek damages for losses from us, which, if successful, could have a material adverse effect on our business, operating results or financial condition. In addition, the failure of our software to perform to customer expectations could give rise to warranty claims. Although our license agreements typically contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could negate these limitation of liability provisions. We have not experienced any product liability claims to date. However, a product liability claim brought against us, even if not successful, could be time consuming and costly to defend and could harm our reputation. In addition, although we carry general liability insurance, our current insurance coverage would likely be insufficient to protect us from all liability that may be imposed under these types of claims.

We are a relatively young company and have a limited operating history with which to evaluate our respective business and the prospects of achieving our anticipated growth and of achieving and maintaining profitability.

We commenced operations in September 1996 and commercially released our first software product in September 1998. Active Software, with which we completed a merger in August 2000, was incorporated in September 1995 and commercially released its first software product in August 1996. We have been operating as a combined company since August 2000. If we do not generate sufficient revenue from our business to fund operations, our growth could be limited unless we are willing to incur operating losses that may be substantial and are able to fund those operating losses from our available assets or, if necessary, from the sale of additional capital through public or private equity or debt financings. If we are unable to

grow as planned, our chances of achieving and maintaining profitability and the anticipated or forecasted results of operations could be reduced, which, in turn, could have a material adverse effect on the market price of webMethods’ stock.

Our penetration of the integration software market and the growth of our business achieved in our limited operating history is not necessarily indicative of our ability in the future to continue to penetrate that market and to grow our business as we anticipate. Our software is complex and generally involves significant capital expenditures by our customers. We often have to devote substantial resources to educate prospective customers about the benefits of our software. Our efforts to educate potential customers may not result in our software being accepted by the potential customer or achieving market acceptance. In addition, many of these prospective customers have made significant investments in internally developed or custom systems and would incur significant costs in switching to third party software such as ours. Furthermore, even if our software is effective, our potential customers may not choose it for technical, cost, support, competitive, economic or other reasons. If the market for our software fails to grow or grows more slowly than we anticipate, or if our penetration of the integration software market and the growth of our business is less or slower than we anticipate, our business could suffer, and our ability to achieve and maintain profitability and the anticipated or forecasted results of operations could be reduced, which, in turn, could have a material adverse effect on the market price of webMethods’ stock.

Any future acquisitions of companies or technologies may result in disruptions to our business or the distraction of our management.

We may acquire or make investments in other complementary businesses and technologies in the future. We may not be able to identify other future suitable acquisition or investment candidates, and even if we identify suitable candidates, may not be able to make these acquisitions or investments on commercially acceptable terms, or at all. If we acquire or invest in other companies, we may not be able to realize the benefits we expected to achieve at the time of entering into the transaction. In any future acquisitions, we will likely face many or all of the risks inherent in integrating two corporate cultures, product lines, operations and businesses. Further, we may have to incur debt or issue equity securities to pay for any future acquisitions or investments, the issuance of which could be dilutive to our existing stockholders.

We may not have sufficient resources available to us in the future to take advantage of certain opportunities.

In the future, we may not have sufficient resources available to us to take advantage of growth, product development or marketing opportunities. We may need to raise additional funds in the future through public or private debt or equity financings in order to: take advantage of opportunities, including more rapid international expansion or acquisitions of complementary businesses or technologies; develop new software or services; or respond to competitive pressures. Additional financing needed by us in the future may not be available on terms favorable to us, if at all. If adequate funds are not available, not available on a timely basis, or are not available on acceptable terms, we may not be able to take advantage of opportunities, develop new software or services or otherwise respond to unanticipated competitive pressures. In such case, our business, operating results and financial condition could be harmed.

If we are unable to protect our intellectual property, we may lose a valuable asset, experience reduced market share, or incur costly litigation to protect our rights.

Our success depends, in part, upon our proprietary technology and other intellectual property rights. To date, we have relied primarily on a combination of copyright, trade secret, trademark and patent laws, and nondisclosure and other contractual restrictions on copying and distribution to protect our proprietary technology. We have one patent and several pending patent applications for technology related to our software, but we cannot assure you that this patent is valid or that these applications will be successful. A small number of our agreements with customers and system integrators contain provisions regarding the rights of third parties to obtain the source code for our software, which may limit our ability to protect our intellectual property rights in the future. Despite our efforts to protect our proprietary rights, unauthorized parties may copy aspects of our software and obtain and use information that we regard as proprietary. In addition, other parties may breach confidentiality agreements or other protective contracts we have entered

into, and we may not be able to enforce our rights in the event of these breaches. Furthermore, we expect to continue increasing our international operations in the future, and the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States.

Our means of protecting our intellectual property rights in the United States or abroad may not be adequate to fully protect our intellectual property rights. Litigation to enforce our intellectual property rights or protect our trade secrets could result in substantial costs, may not result in timely relief and may not be successful. Any inability to protect our intellectual property rights could seriously harm our business, operating results and financial condition.

Because our software incorporates technology licensed from third parties, the loss of our right to use this licensed technology could harm our business.

We license technology that is incorporated into our software from third parties. Any significant interruption in the supply or support of any licensed software could adversely affect our sales, unless and until we can replace the functionality provided by this licensed software. Because our software incorporates software developed and maintained by third parties, we depend on these third parties to deliver and support reliable products, enhance our current software, develop new software on a timely and cost-effective basis and respond to emerging industry standards and other technological changes. The failure of these third parties to meet these criteria could harm our business.

Because market participants in some markets have adopted industry specific technologies, we may need to expend significant resources in order to address specific markets.

Our strategy is to continue developing our integration software to be broadly applicable to many industries. However, in some markets, market participants have adopted core technologies that are specific to their markets. For example, many companies in the healthcare and financial services industries have adopted industry-specific protocols for the interchange of information. In order to successfully sell our software to companies in these markets, we may need to expand or enhance our software to adapt to these industry-specific technologies, which could be costly and require the diversion of engineering resources.

We adopted a shareholder rights plan in October 2001, and previously implemented certain provisions in our certificate of incorporation and bylaws, that may have anti-takeover effects.

Our Board of Directors adopted a shareholder rights plan and declared a dividend distribution of one right for each outstanding share of webMethods’ stock, payable to stockholders of record at the close of business on October 18, 2001. Each right, when exercisable, entitles the registered holder to purchase certain securities at a specified purchase price, subject to adjustment. The rights plan may have the anti-takeover effect of causing substantial dilution to a person or group that attempts to acquire webMethods on terms not approved by our Board of Directors. The existence of the rights plan could limit the price that certain investors might be willing to pay in the future for shares of webMethods’ stock and could discourage, delay or prevent a merger or acquisition of webMethods, Inc. that stockholders may consider favorable. In addition, provisions of the current certificate of incorporation and bylaws of webMethods, Inc., as well as Delaware corporate law, could make it more difficult for a third party to acquire us with the support of our Board of Directors, even if doing so would be beneficial to our stockholders.

identified upon adoption of this standard is recognized as a cumulative effect of a change in accounting principle. Any impairment loss incurred subsequent to initial adoption of SFAS No. 142 is recorded as a charge to current period earnings. In the event we acquire goodwill subsequent to June 30, 2001 it will not be amortized. We adopted SFAS No. 142 on April 1, 2002 and, at that time, stopped amortizing goodwill that resulted from business combinations completed prior to the adoption of SFAS No. 141. See note 2 to the financial statements (recent accounting pronouncements) for the impact of these standards.

In September 2002, the Financial Accounting Standards Board issued SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities.” This standard is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of this standard is not expected to have a material effect on the Company’s financial position or results of operations.

In December 2002, the FAS issued SFAS No. 148, Accounting for Stock Based Compensation-Transition and Disclosure-an Amendment to FAS 123. SFAS 148 provides two additional transition methods for entities that adopt the preferable method of accounting for stock based compensation. Further, the statement requires disclosure of comparable information for all companies regardless of whether, when, or how an entity adopts the preferable, fair value based method of accounting. These disclosures are now required for interim periods in addition to the traditional annual disclosure. The amendments to SFAS No. 123, which provides for additional transition methods, are effective for periods beginning after December 15, 2002, although earlier application is permitted. The amendments to the disclosure requirements are required for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002.

We are exposed to a variety of risks, including changes in interest rates affecting the return on our investments and foreign currency fluctuations. We have established policies and procedures to manage our exposure to fluctuations in interest rates and foreign currency exchange rates.

Interest rate risk. We maintain our funds in money market accounts, corporate bonds, commercial paper, Treasury notes, and agency notes. Our exposure to market risk due to fluctuations in interest rates relates primarily to our interest earnings on our cash deposits. These securities are subject to interest rate risk inasmuch as their fair value will fall if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from the levels prevailing as of December 31, 2002, the fair value of the portfolio would not decline by a material amount. We do not use derivative financial instruments to mitigate risks. However, we do have an investment policy that would allow us to invest in short-term and long-term investments such as money market instruments and corporate debt securities. Our policy attempts to reduce such risks by typically limiting the maturity date of such securities to no more than twenty-four months with a maximum average maturity to our whole portfolio of such investments at twelve months, placing our investments with high credit quality issuers and limiting the amount of credit exposure with any one issuer.

Foreign currency exchange rate risk. Our exposure to market risk due to fluctuations in foreign currency exchange rates relates primarily to the inter-company balances with our subsidiaries located in Australia, England, France, Germany, Japan, the Netherlands, Korea, Hong Kong, Malaysia, the People’s Republic of China and Singapore. Transaction gains or losses have not been significant in the past, and there is no hedging activity on foreign currencies. We would not experience a material foreign exchange loss based on a hypothetical 10% adverse change in the price of the euro, Great Britain pound, Singapore dollar, Australian dollar, or yen against the U.S. dollar. Consequently, we do not expect that a reduction in the value of such accounts denominated in foreign currencies resulting from even a sudden or significant fluctuation in foreign exchange rates would have a direct material impact on our financial position, results of operations or cash flows.

Notwithstanding the foregoing, the direct effects of interest rate and foreign currency exchange rate fluctuations on the value of certain of our investments and accounts, and the indirect effects of fluctuations in foreign currency could have a material adverse effect on our business, financial condition and results of operations. For example, international demand for our products is affected by foreign currency exchange rates. In addition, interest rate fluctuations may affect the buying patterns of our customers. Furthermore, interest rate and currency exchange rate fluctuations have broad influence on the general condition of the U.S., foreign and global economics, which could materially adversely affect our business, financial condition, results of operations and cash flows.

Within 90 days prior to the filing of this report, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, have conducted an evaluation of the effectiveness of disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures

are effective in ensuring that all material information required to be filed in this quarterly report on Form 10-Q has been made known to them in a timely fashion. There have been no significant changes in internal controls, or in factors that could significantly affect internal controls, subsequent to the date the Chief Executive Officer and Chief Financial Officer completed their evaluation.

On November 30, 2001, a purported class action lawsuit was filed in the Southern District of New York naming webMethods, Inc., several of its executive officers at the time of our initial public offering and the managing underwriters of our initial public offering as defendants. The complaint, as amended, alleges that webMethods’ initial public offering registration statement and final prospectus contained material misrepresentations and omissions related in part to certain commissions allegedly solicited and received by the underwriters, and tie-in arrangements allegedly demanded by the underwriters, in connection with their allocation of shares in our initial public offering. The complaint seeks unspecified damages on behalf of a purported class of purchasers of common stock between February 10, 2000 and December 6, 2000. This case is at an early stage and has been consolidated with similar actions; the defendant issuers have moved to dismiss part or all of the complaints. Management believes that the claims against webMethods and its officers are without merit, and we intend to defend against the complaint vigorously.

From time to time, the Company is involved in other disputes and litigation in the normal course of business.

On February 10, 2000, in connection with our initial public offering, a Registration Statement on Form S-1 (No. 333-91309) was declared effective by the Securities and Exchange Commission, pursuant to which 4,715,000 share of our common stock were offered and sold for our account at a price of $35.00 per share, generating aggregate gross proceeds of $165 million for the account of the Company. The managing underwriters were Morgan Stanley Dean Witter, Merrill Lynch & Co., Dain Rauscher Wessels and Freidman Billings Ramsey. After deduction approximately $11.6 million in underwriting discounts and $1.5 million in other related expenses, the net proceeds of the offering were approximately $151.9 million. As of December 31, 2002, $151.9 million of the net proceeds were invested in cash and cash equivalents, short-term and long-term investments. We intend to use such proceeds for capital expenditures and for general corporate purposes, including working capital to fund anticipated operating losses.

	(1)		Incorporated by reference to webMethods’ Registration Statement on Form S-4, as amended (File No. 333-39572).

	(2)		Incorporated by reference to webMethods’ Annual Report on Form 10-K for the year ended June 31, 2001 (File No. 001-15681).

	(3)		Incorporated by reference to webMethods’ Registration Statement on Form S-1, as amended (File No. 333-91309).

	(4)		Incorporated by reference to webMethods’ Registration Statement on Form 8-A (File No. 001-15681)

	(5)		Incorporated by reference to webMethods’ Annual Report on Form 10-K for the year ended June 31, 2002 (File No. 001-15681).

			* Filed herewith.

(b) Reports on Form 8-K. webMethods, Inc. filed no reports on Form 8-K since the beginning of its fiscal quarter on October 1, 2002.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


DELAWARE (State or other jurisdiction of incorporation or organization)		54-1807654 (I.R.S. Employer Identification No.)

3930 PENDER DRIVE, FAIRFAX, VIRGINIA (Address of principal executive offices)		22030 (Zip Code)


Part I		Financial Information
Item 1		Financial Statements
		Condensed Consolidated Financial Statements
		Condensed Consolidated Balance Sheets as of December 31, 2002
		(unaudited) and March 31, 2002
		Condensed Consolidated Statements of Operations and Comprehensive
		Loss (unaudited) - Three and nine months ended December 31, 2002
		and 2001
		Condensed Consolidated Statements of Cash Flows (unaudited) - Nine
		months ended December 31, 2002 and 2001
		Notes to Condensed Consolidated Financial Statements (unaudited)
Item 2		Management's Discussion and Analysis of Financial Condition and
		Results of Operations
Item 3		Quantitative and Qualitative Disclosures About Market Risk
Item 4		Controls and Procedures

Part II		Other Information
Item 1		Legal Proceedings
Item 2		Changes in Securities and Use of Proceeds
Item 6		Exhibits and Reports on Form 8-K
		(a) Exhibits
		(b) Reports on Form 8-K


			DECEMBER 31,			MARCH 31,
			2002			2002
			(UNAUDITED)
ASSETS
Current assets:
	Cash and cash equivalents		$	74,264		$	98,497
	Marketable securities available for sale			116,420			113,345
	Accounts receivable, net of allowance of $2,875 and $3,685			44,656			46,417
	Prepaid expenses and other current assets			6,670			7,516


		Total current assets		242,010			265,775
Marketable securities available for sale				9,335			—
Property and equipment, net				13,435			17,181
Goodwill and acquired intangibles, net				29,838			29,838
Other assets				9,648			11,269


		Total assets	$	304,266		$	324,063


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	9,015		$	15,105
	Accrued expenses			14,469			16,170
	Accrued salaries and commissions			12,879			15,594
	Deferred revenue			39,373			37,298
	Current portion of capital lease obligations			3,747			2,699


		Total current liabilities		79,483			86,866
	Capital lease obligations, net of current portion and other			823			1,765
	Long term deferred revenue			9,208			19,888


		Total liabilities		89,514			108,519

Stockholders’ equity:
	Common stock, $0.01 par value; 500,000,000 shares authorized; 51,343,397 and 50,477,383 shares issued and outstanding			513			505
	Additional paid-in capital			514,340			510,281
	Deferred stock compensation and warrant charge			(11,630	)		(14,875	)
	Accumulated deficit			(288,606	)		(279,864	)
	Accumulated other comprehensive income (loss)			135			(503	)


		Total stockholders’ equity		214,752			215,544


		Total liabilities and stockholders’ equity	$	304,266		$	324,063


					THREE MONTHS ENDED						NINE MONTHS ENDED
					DECEMBER 31,						DECEMBER 31,

					2002			2001			2002			2001

Revenue:
	License				$	33,940		$	30,434		$	89,084		$	88,980
	Professional services					7,951			8,852			24,737			27,944
	Maintenance					11,919			9,828			33,832			28,324


		Total revenue				53,810			49,114			147,653			145,248


Cost of revenue:
	License					765			613			1,425			1,965
	Professional services and maintenance:
				Stock based compensation		65			47			218			368
				Other professional services and maintenance costs		10,409			10,050			31,344			32,417


		Total cost of revenue				11,239			10,710			32,987			34,750


Gross profit						42,571			38,404			114,666			110,498
Operating expenses:
	Sales and marketing:
				Stock based compensation and warrant charge		896			411			2,848			2,077
				Other sales and marketing costs		24,309			26,063			71,211			80,372
	Research and development:
				Stock based compensation		26			1,872			85			12,077
				Other research and development costs		12,059			12,219			36,159			37,628
	General and administrative:
				Stock based compensation		—			27			44			166
				Other general and administrative costs		4,758			4,573			13,051			15,187
Restructuring costs						2,237			—			2,237			7,243
Amortization of goodwill and acquired intangibles						—			8,876			—			29,901


		Total operating expenses				44,285			54,041			125,635			184,651


Operating loss						(1,714	)		(15,637	)		(10,969	)		(74,153	)
Interest income, net						975			1,782			3,227			7,189
Impairment of equity investment in private company						—			—			(1,000	)		—


		Net loss			$	(739	)	$	(13,855	)	$	(8,742	)	$	(66,964	)


Basic and diluted net loss per common share					$	(0.01	)	$	(0.28	)	$	(0.17	)	$	(1.36	)


Shares used in computing basic and diluted net loss per common share						51,046,792			49,574,861			50,821,804			49,255,976


Comprehensive loss:
			Net loss		$	(739	)	$	(13,855	)	$	(8,742	)	$	(66,964	)
			Other comprehensive loss:
				Unrealized gain (loss) on marketable securities available for sale		128			(373	)		(102	)		(85	)
				Foreign currency cumulative translation adjustment		414			(240	)		740			(409	)


Total comprehensive loss					$	(197	)	$	(14,468	)	$	(8,104	)	$	(67,458	)


		NINE MONTHS ENDED DECEMBER 31,

		2002			2001

Cash flows from operating activities:
	Net loss	$	(8,742	)	$	(66,964	)
	Adjustments to reconcile net loss to net cash used in operating activities:
	Depreciation and amortization		7,531			6,146
	Provision for allowance for doubtful accounts		214			2,360
	Loss on disposal of equipment		—			572
	Amortization of deferred stock compensation related to employee stock options and non-employee stock warrants		3,195			14,688
	Impairment of equity investment in private company		1,000			—
	Amortization of goodwill and intangibles		—			29,901
Increase (decrease) in cash resulting from changes in assets and liabilities:
	Accounts receivable		3,392			13,880
	Prepaid expenses and other current assets		1,039			3,736
	Other non-current assets		910			(378	)
	Accounts payable		(6,699	)		76
	Accrued expenses		(1,928	)		8,956
	Accrued salaries and commissions		(2,493	)		(155	)
	Accrued ESPP		(891	)		(2,497	)
	Deferred revenue		(10,054	)		(9,603	)


Net cash (used in) provided by operating activities			(13,526	)		718


Cash flows from investing activities:
	Purchases of property and equipment		(2,459	)		(4,642	)
	Net purchases of marketable securities available for sale		(12,515	)		(42,860	)
	Sale of investment in private company		—			2,000


	Net cash used in investing activities		(14,974	)		(45,502	)


Cash flows from financing activities:
	Borrowings under leasing agreements		2,500			—
	Payments on capital leases		(3,467	)		(2,167	)
	Proceeds from exercise of stock options and stock issued under the ESPP		4,119			8,321


Net cash provided by financing activities			3,152			6,154
Effect of exchange rate on cash and cash equivalents			1,115			(236	)


Net decrease in cash and cash equivalents			(24,233	)		(38,866	)
Cash and cash equivalents at beginning of period			98,497			109,713
Cash and cash equivalents at end of period		$	74,264		$	70,847


	THREE MONTHS ENDED DECEMBER 31,						NINE MONTHS ENDED DECEMBER 31,
	2002			2001			2002			2001

Net loss	$	(739	)	$	(13,855	)	$	(8,742	)	$	(66,964	)
Adjustments:
Amortization of goodwill		—			8,849			—			29,691

Adjusted net loss	$	(739	)	$	(5,006	)	$	(8,742	)	$	(37,273	)
Weighted average shares-basic and diluted		51,046,792			49,574,861			50,821,804			49,255,976

Adjusted basic and diluted EPS	$	(0.01	)	$	(0.10	)	$	(0.17	)	$	(0.76	)
Reported basic and diluted EPS	$	(0.01	)	$	(0.28	)	$	(0.17	)	$	(1.36	)


		AS OF		AS OF
		DECEMBER 31,		MARCH 31,
LONG LIVED ASSETS		2002		2002

Americas		$	58,830	$	55,360
Europe			1,885		1,555
Asia Pacific			1,541		1,373


	Total	$	62,256	$	58,288


Exhibit
Number		Description

2.1(1)		Agreement and Plan of Merger dated as of May 20, 2000, by and among webMethods, Inc., Wolf Acquisition, Inc. and Active Software, Inc.
3.1(2)		Fifth Amended and Restated Certificate of Incorporation of webMethods, Inc., as amended
3.2(3)		Amended and Restated Bylaws of webMethods, Inc.
4.1(3)		Specimen certificate for shares of webMethods Common Stock
4.2(4)		Rights Agreement dated as of October 18, 2001 between webMethods, Inc. and American Stock Transfer & Trust Company.
10.1(3)		Second Amended and Restated Investor Rights Agreement
10.2(5)		webMethods, Inc. Amended and Restated Stock Option Plan
10.3(3)		Employee Stock Purchase Plan
10.4(3)		Indemnification Agreement entered into between webMethods, Inc. and each of its directors and executive officers
99.1*		Certification of Chief Executive Officer
99.2*		Certification of Chief Financial Officer


		WEBMETHODS, INC

Date: February 7, 2003		By: /s/ PHILLIP MERRICK

		Phillip Merrick Chairman of the Board and Chief Executive Officer



Date: February 7, 2003		By: /s/ MARY DRIDI

		Mary Dridi Chief Financial Officer (Principal Financial Officer)


	Three Months Ended							Nine Months Ended

	December 31,		December 31,		Percentage			December 31,		December 31,		Percentage
	2002		2001		Change			2002		2001		Change

Americas	$	38,847	$	35,130		11	%	$	102,112	$	105,442		(3	)%
Europe		9,463		8,734		8	%		26,001		26,552		(2	)%
Asia Pacific		5,500		5,250		5	%		19,540		13,254		47	%

Total Revenue	$	53,810	$	49,114		10	%	$	147,653	$	145,248		2	%


	December 31,		March 31,
	2002		2002

	(in thousands)
Cash, marketable securities and long term marketable securities	$	200,019	$	211,842
Working capital	$	162,527	$	178,909