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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

    (Mark One)

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

FOR THE THREE MONTHS ENDED JUNE 30, 2003

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

Commission File Number
1-15681

webMethods, Inc.

(Exact name of Registrant as Specified in its Charter)

Registrant’s telephone number, including area code: (703) 460-2500

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value
Preferred Stock Purchase Rights

     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 þ No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes þ No o

     As of August 4, 2003, there were outstanding 52,027,727 shares of the registrant’s Common Stock.

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WEBMETHODS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED JUNE 30, 2003
TABLE OF CONTENTS

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PART I

FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

WEBMETHODS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

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

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WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(UNAUDITED)

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

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WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

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

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

1. BASIS OF PRESENTATION

     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, 2003. 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 that, 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 months ended June 30, 2003 are not necessarily indicative of the results to be expected for the full year or any future period. Certain amounts previously reported have been reclassified to conform with current year presentation.

2. PRO FORMA STOCK BASED COMPENSATION

     The Company measures compensation expense for its employee stock-based compensation using the intrinsic value method and provides pro forma disclosures of net loss as if the fair value method had been applied in measuring compensation expense. Under the intrinsic value method of accounting for stock based compensation, when the exercise price of options granted to employees is less than the fair value of the underlying stock on the grant date, compensation expense is recognized over the applicable vesting period.

     The following table summarizes the Company’s results on a pro forma basis as if it had recorded compensation expense based upon the fair value at the grant date for awards consistent with the methodology prescribed in SFAS 123, “Accounting for Stock-Based Compensation,” for quarters ended June 30, 2003 and 2002:

     The fair value of each option grant is estimated on the date of grant using the Black-Scholes valuation model with the following weighted average assumptions: Risk-free interest rates of 2.93% and 4.40% for the quarters ended June 30, 2003 and 2002, respectively; expected volatility of 97% and 125% for the quarters ended June 30, 2003 and 2002, respectively; expected life of 4 years, and no anticipated dividends.

     The weighted average fair value per share for stock option grants that were awarded during the quarters ended June 30, 2003 and 2002 was $8.93 and $12.25, respectively.

3. COMPUTATION OF NET LOSS PER SHARE

     The Company’s net loss per share calculation for basic and diluted is based on the weighted average number of common shares outstanding. There are no reconciling items in the numerator and denominator of the Company’s net loss per share calculation. Employee stock options and warrants of 1,709,992 and 983,975 for the quarters ended June 30, 2003 and 2002, respectively, have been excluded from the net loss per share calculation because their effect would be anti-dilutive.

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4. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION

5. SEGMENT INFORMATION

     The Company conducts operations worldwide and is primarily managed on a geographic basis with those geographic segments being the Americas, Europe, Japan 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:

6. RESTRUCTURING CHARGES

     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 taken to align the Company’s cost structure with changing market conditions. The restructuring plan resulted in headcount reduction of approximately 150 employees or 14% of the workforce. The Company reduced the number of facilities by closing excess field offices and consolidating several California facilities into two locations.

     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 June 30, 2003 and March 31, 2003, respectively, $1.5 million and $1.8 million of restructuring charges remained unpaid. This portion primarily relates to rent on the excess facilities and will be paid over the remaining rental periods.

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7. INVESTMENTS IN PRIVATE COMPANIES

     In April 2000, the Company made an investment in a third-party totaling $2,000,000 of which $1,000,000 was equity and $1,000,000 was convertible debt. The Company and this third-party share a common Board member. In March 2002, the Company recorded an other-than-temporary decline in value of $200,000 in the equity investment. In June 2003, the Company received $1,000,000 as repayment of it’s convertible debt to this private company. In connection with this transaction, the Company also converted $257,000 of interest receivable into additional equity in this private company. As of June 30, 2003 and 2002, the carrying value of the investment in this third-party was $1,057,000 and $1,800,000, respectively, and the Company’s equity position, excluding conversion of the debt, was less than 4%.

     The Company incurred royalty expense of $363,000 to this investment in the quarter ended June 30, 2003. The Company did not incur royalty expense to this third-party for the quarter ended June 30, 2002.

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 on 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 quarterly report on Form 10-Q 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. 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, sufficiency of working capital and projections regarding the market for integration software, (ii) statements of the plans or objectives of webMethods, Inc. or its management, including the development or enhancement of software, development and continuation of strategic partnerships and alliances, execution of potential acquisitions of technology or companies, implementation and effect of sales and marketing initiatives by webMethods, strength of results from geographic or specific vertical markets and allocation of resources to those markets, predictions of the timing and type of customer or market reaction to those initiatives, the ability to control expenses, future hiring, webMethods’ business strategy and the execution on it and actions by customers and competitors, (iii) statements of future economic performance, economic conditions or the impact of recent changes in accounting standards and (iv) assumptions underlying any of the foregoing. In some instances, forward-looking statements can be identified by the use of the words “believes,” “anticipates,” “plans,” “expects,” “intends,” “may,” “will,” “should,” “estimates,” “predicts,” “continue”, the negative thereof or similar expressions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, our expectations or the forward-looking statements could prove to be incorrect, and actual results could differ materially from those indicated by the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to risks and uncertainties, including (but not limited to) those discussed in Item 1 of our Form 10-K for the year ended March 31, 2003 under the caption “Factors That May Affect Future Operating Results” and under this Item under the caption “Factors That May Affect Future Operating Results”. Achieving the future results or accomplishments described or projected in forward-looking statements depends upon events or developments that are often beyond our ability to control. All forward-looking statements and all reasons why actual results may differ that are included in this report are made as of the date of this report, and webMethods disclaims any obligation to publicly update or revise such forward-looking statements or reasons why actual results may differ.

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OVERVIEW

Background

     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

Overview of First Quarter of Fiscal 2004

     Our net loss of $6.8 million for the quarter ended June 30, 2003 increased by $3.7 million from a net loss of $3.1 million in the quarter ended June 30, 2002. The increase in net loss is due primarily to a decrease in revenue of $4.5 million, an increase in professional services and maintenance costs of $1.4 million, and a $405,000 decrease in net interest income, which was partially offset by a $2.9 million decrease in operating expenses.

     Total revenue decreased to $43.2 million for the quarter ended June 30, 2003 from $47.7 million for the quarter ended June 30, 2002. This decrease was a result of a reduction of license revenue by $6.9 million, which was partially offset by an increase of $1.7 million in maintenance revenue in the quarter ended June 30, 2003 compared to the same quarter in the prior year. The 24% decrease in license revenue is attributable to the continued uncertainty in the global economy and in information technology spending, which affected our North American commercial license sales in our first 2004 fiscal quarter ended June 30, 2003. During the first quarter of our fiscal year 2004, many enterprises continued to be cautious, and information technology (IT) purchases were subjected to rigorous internal reviews and approvals which often resulted in longer sales cycles, the postponement of IT projects, customers placing smaller orders, or difficulty in closing large deals. Additionally, we entered the first quarter of our fiscal year 2004 with our quota bearing sales headcount down approximately 10% from the quarter ended June 30, 2002. While we knew this may have some impact, we did not anticipate the extent to which it would impact our coverage and pipeline development. During our first quarter of fiscal year 2004, we hired additional quota bearing sales representatives, which moves us closer to our desired level of coverage.

     We maintained our intense focus on managing operating expenses throughout the quarter ended June 30, 2003. This resulted in a 6% reduction in operating expenses which is a result of reductions in total sales and marketing, research and development and general and administrative expenses, excluding stock based compensation and warrant charge, compared to the same quarter in the prior year.

     We sell our integration platform to Global 2000 customers through our direct sales force augmented by system integrators, our relationships with application software partners, and to a lesser extent, resellers. We license our software to customers primarily on a perpetual basis and to a lesser extent, on a renewable term basis. As of June 30, 2003, we had over 975 customers, compared to over 850 customers as of June 30, 2002.

     We believe one of our competitive differentiators is our strong partnership with application software companies and system integrators. Under our partnerships with application software vendors, the partner may resell or embed our software with their applications under limited use licenses for a license or royalty fee. Leading enterprise application software vendors with whom we have strong relationships include i2 Technologies, Informatica, J.D. Edwards, SAP AG and Siebel Systems. 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. We believe our partners influenced, directly or indirectly, a substantial portion of our license revenue during the first quarter of fiscal year 2004, and we expect this influence to continue. Under certain partnership arrangements, we may share license fees derived from joint selling opportunities with our partner. 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 payment of license fees from the joint customer is received. During the first quarter of fiscal year 2004, we expanded our partnership with Informatica to make Business Activity Monitoring more easily attainable and announced our integration of the JBoss application server directly into the webMethods Integration Platform.

     We believe our strong focus and track record of ensuring that our software is successfully put into production (“production event”) is a strong competitive advantage and differentiator. During the first quarter of fiscal year 2004, our global customer services group reported and documented over 100 separate production events as compared to over 75 such events in the prior year. In many instances during the first quarter of fiscal year 2004, these customers deployed our software within 17 weeks or less. Ensuring that our customers successfully implement our software in a timely manner enables them to achieve a greater return on their investment and, in many cases, encourages them to purchase additional software for other integration projects and serve as a reference customer for us in our future sales efforts.

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     We believe the software integration market will continue to provide opportunity for long term growth. Our focus on customer success and satisfaction has resulted in an increasing number of referenceable customers and productions events. Approximately 45% of our license revenue in the first quarter of fiscal year 2004 came from our existing customers. We strive to provide the most comprehensive integration platform available, and will continue to invest to ensure an advantageous positioning relative to our competition, resulting in recognized industry and technology leadership and increasing market share.

Critical Accounting Policies and Estimates

     Our discussion and analysis of our financial condition and results of operations are based upon our condensed 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 from 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.

Revenue Recognition

     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). See Note 2 of the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2003 for a more comprehensive discussion of our revenue recognition policies. Judgments we make regarding these items, including collection risk, can materially impact the timing of recognition of license revenue.

     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 current revenue recognition policies. We continue to evaluate our revenue recognition policies as new authoritative interpretations and guidance are published, and where appropriate, may modify our revenue recognition policies. 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 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 policies is incorrect, the revenue recognized by webMethods could be impacted.

Allowance for Doubtful Accounts

     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 credit-worthiness of each customer with a receivable balance, determined by credit reports from third parties, published or publicly available financial information, customers 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.

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Goodwill and Intangibles Assets

     We record goodwill and intangible assets when we acquire other companies. The allocation of acquisition cost to intangible assets and goodwill involves the extensive use of management’s estimates and assumptions, and the result of the allocation process can have a significant impact on our future operating results. Financial Accounting Standards Board No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), which was issued during fiscal year 2002 and adopted by us on April 1, 2002, eliminated the amortization of goodwill and indefinite lived intangible assets. Intangible assets with finite lives are amortized over their useful lives while goodwill and indefinite lived assets are not amortized under SFAS 142, but are periodically tested for impairment. In accordance with SFAS 142, all of our goodwill is 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. Goodwill is tested for impairment using a two-step process. The first step is to identify a potential impairment and the second step measures the amount of the impairment loss, if any. Goodwill is deemed to be impaired if the carrying amount of the asset exceeds its estimated fair value.

Foreign Currency Effects

     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.

Accounting for Income Taxes

     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 assets 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.

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RESULTS OF OPERATIONS

     The following table summarizes the results of our operations for the fiscal quarters ended June 30, 2003 and 2002 (all percentages are calculated using the underlying data in thousands):

     Total revenue decreased by 9%, to $43.2 million for the quarter ended June 30, 2003 from $47.7 millions for the quarter ended June 30, 2002 due primarily to a decrease in license revenue, which was partially offset by an increase in maintenance and professional services revenue. This decrease in license revenue reflects the continued global economic slowdown and decline in information technology spending.

     Our net loss of $6.8 million for the quarter ended June 30, 2003 increased by $3.7 million from a net loss of $3.1 million in the quarter ended June 30, 2002. The increase in net loss is due primarily to a decrease in total revenue of $4.5 million, an increase in the cost of maintenance and professional services of $1.4 million and a $405,000 decrease in net interest, which was partially offset by a $2.9 million decrease in operating expenses. Additionally, our total expenses included a $2.4 million negative foreign currency impact.

Revenue

     The following table summarizes our revenue for fiscal quarters ended June 30, 2003 and 2002:

     The following table summarizes the Company’s net revenue by geographic region for the fiscal quarters ended June 30, 2003 and 2002:

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     Total revenue decreased to $43.2 million for the quarter ended June 30, 2003 from $47.7 million for the quarter ended June 30, 2002. License revenue decreased by $6.9 million for the quarter ended June 30, 2003 from $28.7 million for the quarter ended June 30, 2002, which was partially offset by an increase of $1.7 million in maintenance revenue in the quarter ended June 30, 2003 from the same quarter in the prior year.

     In the quarter ended June 30, 2003, revenue from the Americas declined 23% to $25.3 million from $32.8 million in the quarter ended June 30, 2002 due primarily to the continued uncertainty in the global economy and in information technology spending, which affected our North American commercial license sales in the quarter ended June 30, 2003. During the first quarter of our fiscal year 2004, many enterprises continued to be cautious, and information technology (IT) purchases were subjected to rigorous internal reviews and approvals which often resulted in longer sales cycles, the postponement of IT projects, customers placing smaller orders, or difficulty in closing large deals. International revenue increased from $14.9 million in the quarter ended June 30, 2002 to $17.9 million in the quarter ended June 30, 2003 primarily due to $2.4 million in positive foreign currency impacts and additional license sales. International revenue accounted for 41% of our total revenue in the quarter ended June 30, 2003, as compared to 31% in the quarter ended June 30, 2002.

     License revenue decreased by 24% to $21.8 million in the quarter ended June 30, 2003 from $28.7 million in the quarter ended June 30, 2002 due to a decline in license revenue in the Americas attributable to the global economic slowdown and decrease in technology spending. Additionally, we entered the first quarter of our fiscal year 2004 with our quota bearing sales headcount down approximately 10% from the quarter ended June 30, 2002.

     Professional services revenue increased 8% to $8.9 million in the quarter ended June 30, 2003 from $8.2 million in the quarter ended June 30, 2002. This increase in professional services revenue is attributable to increased billable hours.

     Maintenance revenue increased 16% to $12.6 million in the quarter ended June 30, 2003 from $10.8 million in the quarter ended June 30, 2002. This increase is due primarily to the increase in customers licensing our software, and the cumulative effect of agreements for post-contract maintenance and support, which are recognized as revenue ratably over the term of the agreement.

Gross Profit

     The following table summarizes the Company’s gross profit by type of revenue, excluding stock based compensation:

     Total gross profit, excluding stock based compensation, decreased to 72% in the quarter ended June 30, 2003 from 78% in the quarter ended June 30, 2002. This decrease was due to a decrease in license revenue and an increase in our cost of licenses as well as an increase in the cost of professional services and maintenance which is a result of increased subcontractor costs.

     Our cost of license revenue consists of royalties for products licensed from third parties. Our gross profit on license revenue was 98% and 99% in the quarter ended June 30, 2003 and 2002, respectively. The decrease in license gross profit is due to an increase in the licensing of royalty bearing products and a decrease in license revenue.

     Our cost of professional services and maintenance consists of costs related to internal professional services and support personnel, and subcontractors hired to provide implementation and support services. Our gross profit on maintenance and services, excluding stock based compensation, was 46% in both quarters ended June 30, 2003 and 2002.

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Operating Expenses

     The following table presents certain information regarding the Company’s operating expenses during the fiscal quarters ended June 30, 2003 and 2002:

*		Excludes stock based compensation and warrant charge, as applicable.

     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 and warrant charge, as applicable.

     Sales and marketing expense, excluding stock based compensation and warrant charge, was 52% and 51% of total revenue in the quarters ended June 30, 2003 and 2002, respectively. In the quarter ended June 30, 2003, sales and marketing expense decreased to $22.5 million from $24.3 million in the quarter ended June 30, 2002, excluding stock based compensation. This decrease was primarily due to a decrease in the number of sales and marketing employees, commission expense, travel, sales referral fees and marketing programs expense.

     Research and development expense, excluding stock based compensation, was $11.2 million and $12.3 million in the quarters ended June 30, 2003 and 2002, which represents 26% of total revenue, respectively. In the quarter ended June 30, 2003, research and development expense, excluding stock based compensation, decreased $1.1 million from the quarter ended June 30, 2002 primarily due to an decrease in the number of research and development personnel and external consultants.

     General and administrative expense, excluding stock based compensation, as a percentage of total revenue was approximately 10% and 9% for the quarters ended June 30, 2003 and 2002, respectively. In the quarter ended June 30, 2003, general and administrative expense, excluding stock based compensation, increased $358,000 from the quarter ended June 30, 2002, to $4.4 million. This increase is primarily due to an increase in personnel costs and other miscellaneous general and administrative expenses.

     Stock based compensation and warrant charge was $721,000 and $1.1 million in the quarters ended June 30, 2003 and 2002, respectively, of which $22,000 and $76,000, respectively, was included in cost of sales. Deferred stock based compensation and warrant charge was recorded for the following transactions:

     (i)  The issuance of restricted stock in connection with certain acquisitions and the grant of stock options to employees and non-employee directors at exercise prices less than the deemed fair value of our common stock at the date of the grant; and

     (ii) In March 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 was 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 amended agreement, i2 will pay us OEM fees of $8.8 million over the amended 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.

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Interest Income, net

     Net interest income decreased by approximately $405,000, or 30%, to $934,000 for the quarter ended June 30, 2003 from $1.3 million for the quarter ended June 30, 2002. This decrease was primarily attributable to lower interest rates on commercial paper, corporate bonds and money market funds in the quarter ended June 30, 2003, compared to those in the same period in the prior year.

Income Taxes

     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.

LIQUIDITY AND CAPITAL RESOURCES

     Historically we have financed our operations and met our capital requirements though the sales of equity securities. Our liquidity and financial position at June 30, 2003, showed a 1% decrease in our cash and investments, to $205.4 million and a 6% decrease in our working capital, to $159.2 million from our positions at June 30, 2002. The decrease in working capital is primarily due to a decrease in our cash and cash equivalents and accounts receivable balances at June 30, 2003, as compared to June 30, 2002.

     Net cash provided by operating activities was $3.3 million for the quarter ended June 30, 2003 and net cash used by operating activities was $8.9 million for the quarter ended June 30, 2002. The increase in cash provided by operating activities during the quarter ended June 30, 2003, compared to quarter ended June 30, 2002, was due primarily to larger decreases in accounts receivable balance offset by smaller decreases in accounts payable, accrued expenses, accrued salaries and commissions, accrued ESPP and deferred revenue.

     Net cash provided by investing activities was $14.8 million and $23.9 million in the quarters ended June 30, 2003 and 2002, respectively. The decrease in cash provided by investing activities was primarily due to the reduction in the sale of marketable securities available for sale. Capital expenditures were $890,000 and $921,000 in the quarters ended June 30, 2003 and 2002, 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 through capital leases and the use of working capital. Additionally, for the quarter ended June 30, 2003, we received $1.0 million in proceeds from the sale of a substantial portion of an investment in a private company.

     Net cash provided by financing activities was $31,000 and $4.2 million in the quarters ended June 30, 2003 and 2002, respectively. These cash flows primarily reflect net cash proceeds from exercises of stock options and Employee Stock Purchase Plan common stock issuances offset by payments on capital leases in the quarters ended June 30, 2003 and 2002 and borrowings under lease agreements in the quarter ended June 30, 2002. Net cash proceeds from exercises of stock options were $262,000 and $685,000 in quarters ended June 30, 2003 and 2002 respectively. Net cash proceeds from ESPP common stock issuances were $1.2 million and $1.7 million in the quarters ended June 30, 2003 and 2002 respectively. Payments on capital leases were $1.5 million and $653,000 in quarters ended June 30, 2003 and 2002, respectively. Borrowings on capital leases were $2.5 million in the quarter ended June 30, 2002.

     We have a line of credit to borrow up to a maximum principal amount of $20,000,000 with a maturity date of October 10, 2003, which we expect to renew. Any borrowings under this line bear interest at the bank’s prime rate per annum. As of June 30, 2003, we had not borrowed against this line of credit. In connection with the line of credit, we have a letter of credit totaling $355,000 related to an office lease. Borrowings under this line are limited to 80% of eligible accounts receivable.

     We believe that our existing working capital and our line of credit will be sufficient to meet our operating resource expenditure requirements for at least the next twelve 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.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

     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.

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Unanticipated fluctuations in our quarterly revenue or operating results could significantly 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, economic uncertainties, economic consequences or after-effects of terrorist acts, geopolitical developments or uncertainties, infectious outbreaks like SARS, travel limitations and other major, unanticipated events may impact our quarterly operating results. We generaly close 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 August 1, 2003, the closing price of webMethods’ stock on the Nasdaq National Market 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, seasonal factors or major, unanticipated events, 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 in some or all of the geographic regions in which we operate. For example, the growth rate for revenue from sales of our software and services during summer months may be lower than at other times during the 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 economic uncertainties and economic consequences or after- effects of terrorist acts, geopolitical developments or uncertainties, infectious outbreaks like SARS, travel limitations 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.

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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 application software vendors with whom we currently have strategic relationships are offering competitive solutions or 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 could harm our business.

Third-party claims that we infringe upon their intellectual property rights may 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 are subject to, and 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. Because our software is integrated with our customers’ networks and business processes, as well as other software applications, third parties may bring claims of infringement against us, as well as our customers and other software suppliers, if the cause of the alleged infringement cannot easily be determined. 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 may be very time-consuming and may 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

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that could prevent us from selling our software or require that we re-engineer some or all of our products. 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. In addition, although we carry general liability insurance, our current insurance coverage may not apply to, and likely would not protect us from, all liability that may be imposed under these types of claims.

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 and risks unique to government contracts that may have a detrimental impact on our business or operating results.

     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 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. Further, some agencies within the US Government may also require some or all of our personnel to obtain a security clearance or may require us to add features or functionality to our software. If our key personnel are unable to obtain or retain this clearance or if we cannot or do not provide required features or functionality, we may be unsuccessful in our bid for some government contracts.

     Contracts with the US Government or with many state and local governments also 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. 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. 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. 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.

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     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, 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.

     We currently do not engage in any currency hedging transactions. Our foreign sales generally are invoiced in the local currency, and, as we expand our international operations or if there is continued volatility in exchange rates, our exposure to gains and losses in foreign currency transactions may increase when we determine that foreign operations are expected to repay intercompany debt in the foreseeable future. Moreover, the costs of doing business abroad may increase as a result of adverse exchange rate fluctuations. For example, if the United States dollar declines in value relative to a local currency and we are funding operations in that country from our U.S. operations, we could be required to pay more for salaries, commissions, local operations and marketing expenses, each of which is paid in local currency. In addition, exchange rate fluctuations, currency devaluations or economic crises may reduce the ability of our prospective customers to purchase our software and services.

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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. 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, other performance problems or failure to provide support 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 potential product liability claims, existing or future laws or unfavorable judicial decisions could negate these limitation of liability provisions. Although we have not experienced any product liability claims to date, sale and support of our software entail the risk of such claims. The integration of our software with our customers’ networks and software applications increases the risk that a customer may bring a lawsuit against several suppliers if an integrated computer system fails and the cause of the failure cannot easily be determined. Even if our software is not at fault, 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 maintaining profitability.

     We commenced operations in June 1996. Active Software, with which we completed a merger in August 2000, was incorporated in September 1995. 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 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.

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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 some of our software products incorporate technology licensed from, or provided by, third parties, the loss of our right to use that technology could harm our business.

     Some of our software products contain technology that is licensed from, or provided by, third parties. Any significant interruption in the supply or support of any of that third-party software could adversely affect our sales, unless and until we can replace the functionality provided by the third-party software. Because some of 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. In other instances we provide third-party software with our current software and offer support for the third party software, and we depend on these third-parties to deliver reliable products, provide underlying product support 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.

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     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 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. 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 without the support of our Board of Directors, even if doing so would be beneficial to our stockholders.

ITEM 3. QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     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 June 30, 2003, 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 intercompany balances with our subsidiaries located in Australia, England, France, Germany, Japan, the Netherlands, Korea, Hong Kong 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.

ITEM 4. CONTROLS AND PROCEDURES

     As of June 30, 2003, webMethods’ management, including our 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 have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. 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.

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PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     On November 30, 2001, a purported class action lawsuit was filed in the Southern District of New York naming webMethods, 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 amended complaint alleges, among other things, 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, and that those commissions and arrangements were not disclosed to the public after webMethods’ initial public offering. The amended complaint also alleges that false analysts’ reports were issued. The amended complaint seeks unspecified damages on behalf of a purported class of purchasers of webMethods common stock between February 10, 2000 and December 6, 2000. This case has been consolidated as part of In Re Initial Public Offering Securities Litigation (SDNY). We have considered and agreed to enter into a proposed settlement offer with representatives of the plaintiffs in the consolidated proceeding, and believe that any liability on behalf of webMethods that may accrue under that settlement offer would be covered by our insurance policies. Until that settlement is fully effective, we intend to defend against the amended complaint vigorously.

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

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(a)

Exhibits.

(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 March 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 March 31, 2002 (File No.

001-15681).

*

Filed herewith.

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     (b) Reports on Form 8-K. The following reports on Form 8-K have been filed by webMethods, Inc. since the beginning of its fiscal quarter on April 1, 2003:

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SIGNATURES

     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.

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