UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

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, $0.01par 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 [x] No [  ]

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

     As of February 12, 2004, there were outstanding 52,624,711 shares of the registrant’s Common Stock.

WEBMETHODS, INC.

QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED DECEMBER 31, 2003
TABLE OF CONTENTS

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PART I

FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

WEBMETHODS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share
and per share data)

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 and nine months ended December 31, 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 the three and nine months ended December 31, 2003 and 2002 :

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     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 4.30% for the three and nine months ended December 31, 2003 and 2002, respectively; expected volatility of 97% and 125% for the three and nine months ended December 31, 2003 and 2002, respectively; expected life of 4 years, and no anticipated dividends.

     The weighted average fair value per share for stock option grants awarded during the three months ended December 31, 2003 and 2002 was $8.79 and $7.45, respectively. The weighted average fair value per share for stock option grants awarded during the nine months ended December 31, 2003 and 2002 was $8.88 and $8.83, 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 871,056 and 953,619 for the three months ended December 31, 2003 and 2002, respectively, have been excluded from the net loss per share calculation because their effect would be anti-dilutive. Employee stock options and warrants of 829,031 and 1,194,459 for the nine months ended December 31, 2003 and 2002, respectively, have been excluded from the net loss per share calculation because their effect would be anti-dilutive.

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/Middle-East/Africa (“EMEA”), Japan and Asia Pacific regions. 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:

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6.

RESTRUCTURING CHARGES

     In response to changing market conditions, including the decline in information technology spending, the Company implemented restructuring plans in the second quarter of fiscal 2002, third quarter of fiscal 2003 and third quarter of fiscal 2004.

     During the quarter ended September 30, 2001, the Company recorded a restructuring charge of $7.2 million, consisting of headcount reductions, consolidations of facilities, and other related restructuring charges. During the quarter ended December 31, 2002, the Company recorded a restructuring charge of $2.2 million to further reduce headcount. In addition, in October 2003, the Company recorded a restructuring charge of $1.3 million due to an additional headcount reduction of approximately 39 employees or 4% of the workforce

     As of December 31, 2003 and March 31, 2003, respectively, $2.2 million and $1.8 million of restructuring charges remained unpaid. The accrual primarily relates to rent on excess facilities and severance payable related to the October 2003 restructuring.

7.

INVESTMENTS IN PRIVATE COMPANY

     The Company has an investment in a private company and shares a common Board member. In September 2003, the Company received $1,000,000 as repayment of convertible debt and converted $257,000 of interest into additional equity in this private company. As of December 31, 2003 and March 31, 2003, the carrying value of the investment in this private company was $1,057,000 and $1,800,000, respectively, and the Company’s equity position, excluding conversion of other convertible debt, was less than 4%.

     The Company incurred royalty expense of $320,000 and $483,000 to this private company in the three months ended December 31, 2003 and 2002, respectively, and $1,079,000 and $824,000 in the nine months ended December 31, 2003 and 2002, respectively.

8.

BUSINESS COMBINATIONS AND ACQUISITION OF TECHNOLOGY

     In October 2003, the Company completed the business acquisitions of The Mind Electric, Inc. (“TME”) and The Dante Group, Inc. as well as the asset acquisition of the portal solution previously known as DataChannel. TME was a leading provider of software for service-oriented architectures, and The Dante Group was a provider of business activity monitoring software. DataChannel (previously marketed as PortalMinder by Netegrity) was a comprehensive portal platform for creating secure, identity-driven portals within a scalable architecture.

DataChannel

     The Company acquired the portal solution technology and certain fixed assets from DataChannel for $5,278,000 in cash, including $176,000 in direct acquisition costs. The Company also assumed deferred revenue of $66,000 related to on-going maintenance contracts.

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     The acquisition of the existing portal solution technology of $5,243,000 was recorded as purchased technology and is amortized over the estimated useful life of 60 months. The technology is expected to complement the Company’s existing technology and the incremental efforts required to market the portal solution product were minimal. The Company determined that as of the date of the technology purchase the purchased technology had alternative future use and had attained technological feasibility.

TME and The Dante Group

     The acquisitions of TME and The Dante Group were accounted for under the purchase method of accounting and, accordingly, the results of operations of each acquisition are included in the accompanying unaudited condensed consolidated statements of operations and comprehensive loss since the acquisition date. As a result of these acquisitions, the Company has recorded charges for in-process research and development and has recorded assets related to existing technology.

     In-process research and development represents in-process technology that, as of the date of the acquisition, had not reached technological feasibility and had no alternative future use. Based on valuation assessments, the value of these projects was determined by estimating the projected net cash flows from the sale of the completed products, reduced by the portion of the revenue attributable to developed technology. The resulting cash flows were then discounted back to their present values at appropriate discount rates. Consideration was given to the stage of completion, complexity of the work completed to date, the difficulty of completing the remaining development and the costs already incurred. The amounts allocated to the acquired in-process research and development were immediately expensed in the period the acquisition was completed.

     Existing technology represents purchased technology for which development had been completed as of the date of acquisition. This amount was determined using the income approach. This method consisted of estimating future net cash flows attributable to existing technology for a discrete projection period and discounting the net cash flows to their present value. The existing technology will be amortized over its expected useful life of 60 months.

     The aggregate purchase price for these acquisitions, including $593,000 in direct acquisition costs, has been allocated to the assets acquired and liabilities assumed based upon their estimated fair values at the date of acquisition as follows (in thousands):

     We determined the valuation of the identifiable intangible assets using the income approach and a valuation report from an independent appraiser. The amounts allocated to the identifiable intangible assets were determined through established valuation techniques accepted in the technology and software industries. The Company is in the process of finalizing the valuations of the businesses, thus the allocation of the purchase price is preliminary.

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     The income approach, which includes an analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing the other identifiable intangible assets. Key assumptions included discount factors ranging from 26% to 31%, and estimates of revenue growth, maintenance renewal rates, cost of sales, operating expenses and taxes. The purchase price in excess of the net liabilities assumed and the identifiable intangible assets acquired was allocated to goodwill.

     The following unaudited pro forma supplemental table presents selected financial information as though the purchases of TME and The Dante Group, which may be material acquisitions for this purpose, had been completed at the beginning of the periods presented. The unaudited pro forma data gives effect to actual operating results prior to the acquisition, adjusted to include the pro forma effect of amortization of intangibles, reduction in interest income on cash paid for the acquisitions and the elimination of the charge for acquired in-process research and development. The unaudited pro forma data for the three and nine months ended December 31, 2003, includes a $1.4 million nonrecurring compensation charge for accelerated vesting of options of The Dante Group which occurred just prior to the transaction. These unaudited pro forma amounts do not purport to be indicative of the results that would have actually been obtained if the acquisitions occurred as of the beginning of the periods presented or that may be obtained in the future (in thousands, except per share data):

9.

GOODWILL AND INTANGIBLE ASSETS

     Goodwill

     The change in carrying amount of goodwill for the nine months ended December 31, 2003, is as follows (in thousands):

     Intangible Assets

     The components of identifiable intangible assets are as follows (in thousands):

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     The Company had no intangible assets as of March 31, 2003. During the three and nine months ended December 31, 2003, the Company had amortization of $599,000 related to its intangible assets. The Company is amortizing intangible assets using the straight line method over a 60 month period. As of December 31, 2003, the estimated intangibles amortization expense for each fiscal year ended March 31 is as follows (in thousands):

10.

SUBSEQUENT EVENT

     In February 2004, the Company announced and implemented a restructuring plan designed to further align its cost structure with expected revenue and business requirements. Actions taken included a reduction in the Company’s employee workforce by approximately 20 positions and the consolidation of our Berkeley, California office into our Sunnyvale, California office. The Company is still evaluating the total costs associated with this restructuring.

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

     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 financial performance or financial results, including items such as revenue, costs or expense, cost savings, margins, income or loss, earnings or loss per share, capital expenditures, cash requirements or other financial items or metrics, the impact of expenses on levels of cash and marketable securities, sufficiency of working capital and projections regarding the market for the Company’s current and anticipated software offerings, (ii) statements of the plans or objectives of webMethods, Inc. or its management, including the development or enhancement of software, dates of availability of new products and new releases of existing products, competitive strategies and the impact of competition, development and continuation of strategic partnerships and alliances, contributions to future financial performance of any of our new or existing products, technologies or businesses, contribution to our financial performance by business partners, 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 or our product offerings, the ability to control expenses or achieve projected expense levels, 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.

OVERVIEW

Background

     We are a leading provider of a comprehensive set of products so that our customers can build a Web services infrastructure. Our software products and services provide standards-based, non-proprietary and vendor-neutral solutions that enable customers to run, measure and optimize their business. We deliver

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software products and provide related services that give 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 and to run, manage and optimize the connected information resources, data, business processes and human workflows. By deploying webMethods software, customers can reduce costs, achieve faster time to value, create new revenue opportunities, strengthen relationships with customers, vendors and business partners, increase supply chain efficiencies and analyze and optimize business processes.

     In October 2003, the Company completed the business and asset acquisitions of The Mind Electric, Inc. (“TME”), The Dante Group and the portal solution previously known as DataChannel. TME was a leading provider of software for the service-oriented architectures, and The Dante Group was a provider of business activity monitoring software. The aggregate acquisition cost for these three acquisitions was approximately $32.4 million in cash.

Overview of Third Quarter of Fiscal 2004

     Our net loss of $11.1 million for the quarter ended December 31, 2003 increased by approximately $10.4 million from a net loss of $739,000 in the quarter ended December 31, 2002. The increase in net loss is due primarily to a decrease in revenue of approximately $3.7 million, an increase in cost of revenue of $3.6 million, an increase in operating expenses of $2.4 million and a decrease in net other income of approximately $680,000. The $2.4 million increase in operating expenses includes a $4.3 million in-process research and development charge related to the acquisitions of TME and The Dante Group which occurred during the quarter ended December 31, 2003, partially offset by a decrease of $922,000 in restructuring costs.

     Our total revenue decreased to $50.1 million for the quarter ended December 31, 2003 from $53.8 million for the quarter ended December 31, 2002. Our revenue decrease resulted from a decline in license revenue of $8.9 million, partially offset by a $3.3 million increase in professional services revenue and a $1.9 million increase in maintenance revenue in the quarter ended December 31, 2003 compared to the same quarter in the prior year. The 26% decrease in license revenue was attributable to the continued uncertainty in information technology spending, the residual impact from our quota bearing sales headcount in the Americas being down approximately 10% at the beginning of the first quarter of our fiscal year 2004, and lower-than-anticipated sequential growth in our Americas license sales in our quarter ended December 31, 2003. During the third quarter of our fiscal year 2004, many enterprises headquartered in the Americas continued to be cautious, and information technology purchases were subjected to rigorous internal reviews and approvals which often resulted in longer sales cycles, the postponement of information technology projects, customers placing smaller orders, or difficulty in closing large deals.

     In October 2003, the Company completed the business acquisitions of TME and The Dante Group as well as the asset acquisition of the portal solution previously known as DataChannel. TME was a leading provider of software for service-oriented architectures, and The Dante Group was a provider of business activity monitoring software. DataChannel (previously marketed as PortalMinder by Netegrity) was a comprehensive portal platform for creating secure, identity-driven portals within a scalable architecture.

     We sell our software and services 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. As of December 31, 2003, we had over 1,050 customers, compared to over 900 customers as of December 31, 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 AMS, i2 Technologies, Informatica, Peoplesoft 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 third quarter of our fiscal year 2004, and

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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 second quarter of our fiscal year 2004, Peoplesoft chose our technology to embed within their AppConnect product suite, which will allow our technology to be used for a number of complex business process integration requirements, and AMS chose to embed webMethods Workflow into twelve of their different applications targeted at the United States military and defense market.

     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 third quarter of our fiscal year 2004, our global customer services group reported and documented over 130 separate production events as compared to over 85 such events in the prior year period. 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 referenceable customer for us in our future sales efforts.

     We believe the software integration and web services infrastructure 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 65% of our bookings in the third quarter of our 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 condensed 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.

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     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.

Business Combinations

      We are required to allocate the purchase price of acquired companies to the tangible and intangible assets acquired, liabilities assumed, as well as IPR&D based on their estimated fair values. We engaged independent third-party appraisal firms to assist us in determining the fair values of assets acquired and liabilities assumed. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.

      Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from license sales, maintenance agreements, consulting contracts, customer contracts, and acquired developed technologies and IPR&D projects, and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur.

      Other estimates associated with the accounting for these acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed.

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.

Acquired In-process Research and Development

      Costs to acquire in-process research and development (IPR&D) technologies which have no alternative future use and which have not reached technological feasibility at the date of acquisition are expensed as incurred (see Note 8, The Mind Electric and Dante Group acquisitions).

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 are included in net income or loss in the period in which they occur.

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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.

Restructuring Costs

     We have recorded restructuring costs to align our cost structure with changing market conditions. These restructuring plans resulted in a reduction in headcount and the consolidation of facilities through the closing of excess offices. Our restructuring costs included accruals for the estimated loss on facilities that we intend to sublease based on estimates of the timing and amount of sublease income. We reassess this liability each period based in market conditions. Revisions to our estimates of this liability could materially impact our operating results and financial position in future periods if anticipated events and key assumptions, such as the timing and amounts of sublease rental income, either change or do not materialize.

RESULTS OF OPERATIONS

     The following table summarizes the results of our operations for the three and nine months ended December 31, 2003 and 2002 (all percentages are calculated using the underlying data in thousands):

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     In the nine months ended December 31, 2003, total revenue decreased by 6%, to $138.7 million from $147.7 million for the nine months ended December 31, 2002 due primarily to a decrease in license revenue, which was partially offset by an increase in maintenance and professional services revenue. During the quarter ended December 31, 2003, total revenue decreased $3.7 million, or 7%, compared to the quarter ended December 31, 2002, due primarily to a decrease in license revenue which was partially offset by an increase in maintenance and professional services revenue. The decreases in license revenue in the quarter and nine months ended December 31, 2003, reflect the continued uncertainty in information technology spending, the residual impact of our quota-bearing sales representatives in the Americas being down approximately 10% at the beginning of our fiscal year 2004 and lower-than-anticipated sequential growth in our Americas license sales in the second and third quarters of our fiscal year 2004.

     Our net loss of $22.4 million for the nine months ended December 31, 2003 increased 156% from a net loss of $8.7 million in the nine months ended December 31, 2002, due primarily to a decrease in total revenue of $8.9 million, an increase in the cost of revenue of $7.0 million and a $1.3 million decrease in net other income. Those items were partially offset by a $2.6 million decrease in operating expenses and a $1.0 million impairment charge of an equity investment in a private company. During the quarter ended December 31, 2003, our net loss increased by $10.4 million, or 1405%, compared to the quarter ended December 31, 2002, due primarily to a decrease in total revenue of $3.7 million, an increase in the cost of revenue of $3.6 million, an increase in operating expenses of $2.4 million and a $680,000 decrease in net other income. Operating expenses in the quarter and nine months ended December 31, 2003 included a $4.3 million in-process research & development charge.

Revenue

     The following table summarizes our revenue for the three and nine months ended December 31, 2003 and 2002:

     The following table summarizes our net revenue by geographic region for the three and nine months ended December 31, 2003 and 2002:

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     Total revenue for the quarter and nine months ended December 31, 2003 decreased 7% and 6%, respectively, compared to the quarter and nine months ended December 31, 2002. These decreases were due primarily to decreases in license revenue, which were partially offset by increases in maintenance and professional services revenue. The decreases in total revenue in the quarter and nine months ended December 31, 2003, as well as the decreases in license revenue in those periods, were due primarily to less-than-anticipated sequential growth in Americas license sales in the second and third quarters of our fiscal 2004, which were impacted by factors discussed in the following paragraph. For the quarter and nine months ended December 31, 2003, revenue from EMEA, Asia Pacific and Japan (“international revenue”) increased 41% and 28%, respectively, compared to the quarter and nine months ended December 31, 2002. The increase in international revenue was principally due to our increased focus in the EMEA, Japan and Asia Pacific regions that has resulted in an increased acceptance of our software, an increase in the number of larger deals and an increased customer base.

     License revenue for the quarter and nine months ended December 31, 2003, decreased 26% and 23%, respectively, compared to the quarter and nine months ended December 31, 2002. These decreases reflect the continued uncertainty in information technology spending, the impact of our quota bearing sales representatives in the Americas being down approximately 10% at the beginning of our fiscal year 2004 and lower-than-anticipated growth in our Americas license sales in the second and third quarters of our fiscal year 2004. During the first nine months of our fiscal year 2004, many enterprises headquartered in the Americas remained cautious, and information technology purchases were subjected to rigorous internal reviews and approvals that often resulted in longer sales cycles, the postponement of information technology projects, customers placing smaller orders, or difficulty in closing large deals.

     For the quarter and nine months ended December 31, 2003, professional services revenue increased by 41% and 24%, respectively, compared to the quarter and nine months ended December 31, 2002. These increases in professional services revenue are attributable primarily to an increase in the volume and/or size of customer engagements and the increased use of subcontractors.

     For both the quarter and nine months ended December 31, 2003, maintenance revenue increased by 16% compared to the quarter and nine months ended December 31, 2002. These increases in maintenance revenue were a result of new licenses of 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, for three and nine months ended December 31, 2003 and 2002:

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     Total gross margin, excluding stock based compensation, was 70% and 71% for the three and nine months ended December 31, 2003, respectively. Total gross margin, excluding stock based compensation, was 79% and 78% for the three and nine months ended December 31, 2002, respectively. This decrease year over year was due to the higher contribution of professional services revenue as a percentage of total revenue and the resulting increase of professional services costs as well as the additional amortization of existing technology and customer relationships relating to the business acquisitions of TME and the Dante Group, which occurred during the quarter ended December 31, 2003.

     Our cost of license revenue consists of royalties for products licensed from third parties as well as the amortization of existing technology and customer relationships relating to the business acquisitions of TME and The Dante Group, which occurred during the quarter ended December 31, 2003. We recorded $599,000 of amortization of acquired intangibles for the three and nine months ended December 31, 2003. Our gross margin on license revenue, excluding stock based compensation, was 95% and 98% for the quarters ended December 31, 2003 and 2002, respectively, and 97% and 98% for the nine months ended December 31, 2003 and 2002, respectively. The decrease in license gross margin for the three month period and year over year was due to an increase in amortization of existing technology and customer relationships, an increase in the cost of 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 margin on professional services and maintenance, excluding stock based compensation, was 46% and 48% for the quarters ended December 31, 2003 and 2002, respectively, and 46% for the nine months ended December 31, 2003 and 2002. The increase in our gross margin on professional services for the three month period ended December 31, 2003 compared to the three month period ended December 31, 2002, was due to the increased use of subcontractors which was partially offset by decreased personnel costs due primarily to a reduction in incentive compensation.

Operating Expenses

     The following table presents certain information regarding the Company’s operating expenses during the three and nine months ended December 31, 2003 and 2002:

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     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, recruiting, professional fees, travel, communications and allocated facilities 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, restructuring costs and in-process research and development.

     Sales and marketing expenses, excluding stock based compensation and warrant charge, increased by 1% or approximately $308,000 in the quarter ended December 31, 2003 compared to the quarter ended December 31, 2002. This increase was primarily due to the following expense changes: increased investment in our annual Integration World customer conference; an increase in travel expense which we believe is due in part to increased sales activity related to the recent acquisitions; and an increase in external consulting fees. These increases were offset by a decrease in incentive compensation and commissions due to lower sales bookings. Sales and marketing expenses, excluding stock based compensation and warrant charge, decreased by 4%, or $2.7 million, for the nine months ended December 31, 2003 compared to the nine months ended December 31, 2002. This decrease was primarily due to the following: a decrease in incentive compensation, commissions and referral fees due to lower sales bookings and a decrease in travel expenses due to continued focus on travel cost containment. These decreases were partially offset by the following: increased investment in our annual Integration World customer conference and an increase in external consulting expense. Sales and marketing expenses, excluding stock based compensation and warrant charge, as a percentage of total revenue was 49% and 48% in the nine months ended December 31, 2003 and 2002, respectively and 49% and 45% in the quarters ended December 31, 2003 and 2002, respectively.

     Research and development expenses, excluding stock based compensation, decreased by 5% and 7% in the quarter and nine months ended December 31, 2003, respectively, compared to the quarter and nine months ended December 31, 2002. These decreases were primarily due to a reduction in incentive compensation costs and contractor costs. Research and development expense, excluding stock based compensation, as a percentage of total revenue was 24% in each of the nine months ended December 31, 2003 and 2002, and 23% and 22% in the quarters ended December 31, 2003 and 2002, respectively.

     General and administrative expenses, excluding stock based compensation, decreased by 9%, or $425,000 in the quarter ended December 31, 2003 compared to the quarter ended December 31, 2002. This decrease was primarily due to decreases in business related taxes, professional fees and bad debt expense. These decreases were offset by an increase in business insurance, and to a lesser extent, travel and recruiting costs. General and administrative expenses, excluding stock based compensation, increased by 2%, or $231,000, for the nine months ended December 31, 2003 compared to the nine months ended December 31, 2002. This increase was primarily due to increases in business insurance, recruiting, personnel and professional fees. These increases were offset by decreases in business related taxes, bad debt expense and travel costs. General and administrative expense, excluding stock based compensation, as a percentage of total revenue was 10% and 9% in the nine months ended December 31, 2003 and 2002, respectively, and 9% in each of the quarters ended December 31, 2003 and 2002.

     Stock based compensation and warrant charges were $2.2 million and $3.2 million during the nine months ended December 31, 2003 and 2002, respectively, of which $57,000 and $218,000, respectively, was included in cost of sales. During the quarters ended December 31, 2003 and 2002, stock based compensation and warrant charges were $707,000 and $987,000, respectively, of which $12,000 and $65,000, respectively, was included in cost of sales. Deferred stock based compensation and warrant charges were recorded for the following transactions:

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     (i) The issuance of restricted stock in connection with certain acquisitions during 2000 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 that, 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 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 amortized over the vesting period of the applicable equity arrangement and is shown by expense category.

     In response to changing market conditions, including the decline in information technology spending, we implemented restructuring plans in the second quarter of fiscal 2002, third quarter of fiscal 2003 and third quarter of fiscal 2004. Restructuring costs relating to headcount reductions of approximately 40 employees, or 4% of the workforce, were $1.3 million for the three months and nine months ended December 31, 2003 compared to $2.2 million for the three and nine months ended December 31, 2002 relating to headcount reductions of approximately 45 employees, or 5% of the workforce.

     In-process research and development charges were $4.3 million for the three and nine months ended December 31, 2003. These charges related to the business acquisitions of TME and The Dante Group, which occurred during the quarter ended December 31, 2003. The value of the acquired in process research and development reflects the fair value of the acquired research and development that, as of the date of the acquisitions has not reached technological feasibility and has no alternative future use. The amounts allocated to the acquired in process research and development were immediately expensed in the period the acquisition was completed because the projects associated with the in process research and development efforts had not yet reached technological feasibility and no future alternative used existed for the technology.

Other Income, net

     Other income, net, includes interest income from cash equivalents, marketable securities, long-term investments, interest expense from borrowings under lease agreements and foreign currency exchange gains or losses. Net interest income decreased by $1.3 million, or 40%, to $1.9 million for the nine months ended December 31, 2003 from $3.2 million for the nine months ended December 31, 2002. During the quarter ended December 31, 2003, net other income decreased $680,000, or 70%, to $295,000 from $975,000 for the quarter ended December 31, 2002. These decreases were primarily attributable a decrease in cash and marketable securities balances and lower interest rates on corporate paper, bonds and money market funds in the respective period of our fiscal year 2004, compared to those in the same period in the prior year. Additionally, for the three months ended December 31, 2003, we recorded $211,000 in foreign currency losses resulting from the revaluation of short-term inter-company payables and receivables and other transaction gains and losses.

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 December 31, 2003, showed a 21% decrease in our cash and marketable securities, to $158.6 million, and a 42% decrease in our working capital, to $93.9 million, from our positions at December 31, 2002. The decrease in our cash and marketable securities is due primarily to approximately $32.4 million in cash paid in connection with the acquisitions completed in

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October 2003. Excluding acquisition payments, our cash and marketable securities at December 31, 2003 decreased by approximately $10.6 million as compared to December 31, 2002. The decrease in working capital is primarily due to a decrease in our cash, short-term marketable securities and accounts receivable balances at December 31, 2003, as compared to December 31, 2002.

     Net cash used in operating activities was $12.8 million for the nine months ended December 31, 2003, compared to $13.5 million for the nine months ended December 31, 2002. The decrease in cash used in operating activities during the first nine months of our fiscal year 2004 compared to the first nine months of our fiscal year 2003, was due primarily to a smaller decrease in accounts payable and a larger increase in accounts receivable offset by higher net loss in the nine months ended December 31, 2003.

     Net cash used in investing activities was $6.4 million for the nine months ended December 31, 2003, compared to $15.0 million during the nine months ended December 31, 2002. The decrease in cash used in investing activities during the first nine months of our fiscal 2004 compared to the first nine months of our prior fiscal year was primarily due to the increase in the sale of marketable securities available for sale offset by $32.4 million used in connection with the acquisitions completed in October 2003. Capital expenditures were $2.0 million and $2.5 million for the nine months ended December 31, 2003 and 2002, respectively. Capital expenditures consisted of purchases of 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 nine months ended December 31, 2003, we received $1.0 million in proceeds from the sale of a significant portion of an investment in a private company.

     Net cash provided by financing activities was $523,000 for the nine months ended December 31, 2003, compared to $3.2 million during the nine months ended December 31, 2002. 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 for the nine months ended December 31, 2003 and 2002 and borrowings under lease agreements for the nine months ended December 31, 2002. Net cash proceeds from exercises of stock options were $831,000 and $1.1 million for the nine months ended December 31, 2003 and 2002 respectively. Net cash proceeds from ESPP common stock issuances were $2.5 million and $3.0 million for the nine months ended December 31, 2003 and 2002 respectively. Payments on capital leases were $2.8 million and $3.5 million for the nine months ended December 31, 2003 and 2002, respectively. Borrowings on capital leases were $2.5 million for the nine months ended December 31, 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 9, 2004. Any borrowings under this line bear interest at the bank’s prime rate per annum. As of December 31, 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.

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

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     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, our competitors and the bases of competition, amount and timing of operating cost, the timing and amount of revenue from our new products and businesses, the achievement of cost savings, 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, delays in the availability of new products or new releases of existing products, and other major, unanticipated events may impact our quarterly operating results. We generally 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 February 1, 2004, 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, the timing and amount of revenue from our new products and businesses, and deferrals of purchases due to economic uncertainties, 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 and amount of our revenue, which in turn could cause our quarterly operating results to fluctuate. Any misperception by us in the needs of our customers and prospective customers, or 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 a decline in the price, or volatility in the price, of webMethods’ stock.

Our target markets are highly competitive, and we may not be able to compete effectively.

     The markets for Web services solutions, integration software, business activity monitoring software and portal products is rapidly changing and intensely competitive. There are a variety of methods available to run Web services, integrate software applications, monitor and optimize business processes and workflows and provide user access to available data and 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 our Web services solutions, our integration software, our workflow solution, our business activity monitoring software, our portal product or other solutions we offer or have announced. If

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our technology, software and solutions 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 Web services technologies, integration solutions, workflow or business process management solutions, and business activity monitoring solutions, electronic data interchange vendors, vendors of proprietary enterprise application integration, vendors of portal products, and application server vendors. We also face competition from various providers of application integration technologies to run Web services and companies offering products and services that address specific aspects of application integration or Web services. Further, we face competition from major system integrators, 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, portal or business activity monitoring software or enabling 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 offerings. 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 or delay 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 vendors of competing software or solutions. 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 our target markets 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 or our customers 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, trademarks 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 customers 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 have brought claims of infringement against us or our customers, and may do so in the future. Because our software is integrated with our customers’ networks

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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. We have agreed to indemnify certain of our customers against claims that our software infringes upon the intellectual property rights of others or that implementation of our products involves processes allegedly covered by intellectual property rights of third parties. Furthermore, former employers of our current and future employees may assert that our employees have improperly disclosed confidential or proprietary information to us. Such claims may be with or without merit.

     Claims of alleged infringement, regardless of merit, may have a material adverse effect on our business in a number of ways. Claims 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. In addition, 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. Furthermore, a party making such a claim could secure a judgment that requires us to pay substantial damages, and also include an injunction or other court order that could prevent us from selling our software or require that we re-engineer some or all of our products. We and our customers have been subject to such claims and litigation, and may in the future be subject to additional claims and litigation. We may in the future settle any such claims, regardless of merit, to avoid the cost and uncertainty of continued litigation. Defense of any lawsuit or failure to obtain any such required licenses could significantly harm our business, operating results and financial condition and the price of webMethods common stock. 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, state, local and foreign 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 and other governments also requires businesses to adhere to requirements of soliciting and doing business with government agencies and their contracting officers, and noncompliance could result in penalties, including debarment from further contracting. Further, contracting with the US Government and with other governments requires us 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, local, and foreign 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

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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.

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

     We recently acquired three businesses and technologies, and 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. With respect to our recent acquisitions and potential future acquisitions, we may not be able to realize the benefits we expected to achieve at the time of entering into the transaction. In such acquisitions, we will likely face many or all of the risks inherent in integrating corporate cultures, product lines, operations and businesses. We will be required to train our sales, professional services and customer support staff with respect to acquired software products, which can detract from executing against goals in the current period, and we may be required to modify priorities of our product development, customer support, systems engineering and sales organizations. 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.

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.

     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.

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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, 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 in some international markets. 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 relatively limited operating history with which to evaluate our business and the prospects of achieving our anticipated growth and of maintaining sustained profitability.

     We commenced operations in September 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. In addition, we have recently acquired businesses with limited operating histories. 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 sustained 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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     Our penetration of our markets and the growth of our business achieved in our relatively limited operating history are not necessarily indicative of our ability in the future to continue to penetrate our target markets 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 our target markets 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.

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.

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     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.

     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 December 31, 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

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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 December 31, 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-15. 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, during the quarter ended December 31, 2003 that has materially affected, or is reasonably likely to materially affect, webmethods’ internal control over financial reporting.

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. Those disputes and litigation include situations in which we choose to defend or indemnify customers in actions in which they are alleged to infringe the intellectual property rights of others even though we believe that the alleged intellectual property rights are invalid or that our software does not infringe those rights.

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

(a) Exhibits.

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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 October 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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