UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

		þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES      EXCHANGE ACT OF 1934 FOR THE THREE MONTHS ENDED JUNE 30, 2004
		o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES      EXCHANGE ACT OF 1934

Commission File Number

webMethods, Inc.

(Exact name of Registrant as Specified in its Charter)

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

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

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

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

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

     As of August 4, 2004, there were outstanding 53,077,440 shares of the registrant’s Common Stock.

WEBMETHODS, INC.

QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED JUNE 30, 2004
TABLE OF CONTENTS

PART I

FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

WEBMETHODS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

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

WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(UNAUDITED)

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

WEBMETHODS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

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

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 (the “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, 2004. Certain information and footnote disclosures which are normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to SEC rules and regulations. The information reflects all normal and recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the financial position of the Company, and its results of operations for the interim periods set forth herein. The results for the three months ended June 30, 2004 are not necessarily indicative of the results to be expected for the full year or any future period. Certain amounts previously reported have been reclassified to conform with current year presentation.

2. PRO FORMA STOCK BASED COMPENSATION

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

     The following table summarizes the Company’s results on a pro forma basis as if it had recorded compensation expense based upon the fair value at the grant date for awards consistent with the methodology prescribed in SFAS 123, “Accounting for Stock-Based Compensation,” for quarters ended June 30, 2004 and 2003:

     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:

     The weighted average fair value per share for stock option grants that were awarded during the quarters ended June 30, 2004 and 2003 was $9.78 and $8.93, 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 a non-employee warrant exercisable for 595,405 and 991,083 shares for the quarters ended June 30, 2004 and 2003, 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 regions being the Americas, Europe, Japan and Asia Pacific region. Revenue is primarily attributable to the region in which the contract is signed and the product is deployed. Information regarding geographic regions is as follows:

6. RESTRUCTURING CHARGES

     The Company has recorded restructuring charges to align its cost structure with changing market conditions. These restructuring plans resulted in reductions in headcount and the consolidation of offices.

     During the quarter ended September 30, 2001, the Company recorded a restructuring charge of $7.2 million relating to headcount reductions, consolidation of facilities, and other related restructuring charges. During the quarter ended December 31, 2002, the Company recorded a restructuring charge of $2.2 million due to a further reduction in headcount. During the quarter ended December 31, 2003, the Company recorded a restructuring charge of $1.3 million due to additional headcount reductions. During the quarter ended March 31, 2004, the Company recorded a restructuring charge of $2.6 million due to further headcount reductions, and the consolidation of certain offices.

     As of June 30, 2004 and March 31, 2004, respectively, $2.7 million and $3.1 million of restructuring charges remained unpaid. This portion primarily relates to rent on the excess facilities and will be paid over the remaining rental periods.

     The following table sets forth a summary of total restructuring and related charges, payments made against those charges and the remaining liabilities as of June 30, 2004.

7. INVESTMENTS IN PRIVATE COMPANIES

     In April 2000, the Company made an investment in a third party totaling $2,000,000 of which $1,000,000 was equity and $1,000,000 was convertible debt. The Company and this third party share a common Board member. In March 2002, the Company recorded an other-than-temporary decline in value of $200,000 in the equity investment. In June 2003, the Company received $1,000,000 as repayment of the convertible debt and converted $257,000 of interest income into additional equity. The third party was a business partner of the Company. As of June 30, 2004 and 2003, the carrying value of the investment in this third party was $1,057,000. The Company incurred royalty expense of $36,000 to this third party in the quarter ended June 30, 2004 and $363,000 in the quarter ended June 30, 2003.

8. SUBSEQUENT EVENT

     In July 2004, the Company announced and implemented a restructuring plan consisting of headcount reductions and the consolidation of facilities to further align our cost structure with expected revenue. 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, return to profitability on a pro-forma or GAAP basis, 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, 2004 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 software and services for end-to-end business integration solutions. We offer a set of software products that enable organizations to run, manage and optimize their business. Our software products and related services 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, to view and manage the connected information resources, data, business processes and human workflows and to provide Web services at the enterprise level.

     In October 2003, we completed the business and asset acquisitions of The Mind Electric, Inc. (“TME”), The Dante Group Inc. and the portal solution previously known as Data Channel. TME was a leading provider of software for 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 First Quarter of Fiscal 2005

     Our net loss of $10.8 million for the quarter ended June 30, 2004 increased by $4.0 million from a net loss of $6.8 million in the quarter ended June 30, 2003. The increase in net loss was due primarily to a $7.6 million decrease in license revenue in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003. During the June 2004 quarter, many enterprises unexpectedly became more cautious in their enterprise software spending. They subjected their proposed information technology purchases to rigorous internal reviews and approvals or requests for contract contingencies, which often resulted in longer sales cycles, the postponement of information technology projects, customers placing smaller orders, or difficulty in closing large deals. We did not close a number of expected opportunities we were working on near the end of the June 2004 quarter, and lower closure rates of large transactions near the end of June 2004 across almost every geographic region contributed significantly to our decrease in license revenue compared to the June 2003 quarter. That decrease in license revenue was partially offset by a $4.0 million increase in professional services revenue and a $2.2 million increase in maintenance revenue in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003.

     We maintained our focus on managing operating expenses throughout the quarter ended June 30, 2004 and decreased our operating expenses by $1.0 million in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003. This 3% reduction in operating expenses is a result of reductions in total sales and marketing expense and research and development expense compared to the same quarter in the prior year.

     We license software and sell our services primarily through our direct sales organization augmented by other sales channels, including our strategic software vendor partners, major system integrators with whom we have strategic alliances, other partners and distributors and, to a lesser extent, resellers. We license our software primarily on a perpetual basis and, to a lesser extent, on a renewable term basis. As of June 30, 2004, we had over 1,200 customers, compared to over 975 customers as of June 30, 2003.

     We believe our strong focus and track record of ensuring that our software is successfully put into production is a strong competitive advantage and differentiator. During the first quarter of fiscal year 2005, our global customer services group reported and documented more than 155 separate customer projects going into production events as compared to 100 such events reported and documented during the quarter ended June 30, 2003. Ensuring that our customers put our software into production 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 business integration projects and serve as a reference customer for us in our future sales efforts.

     We believe one of our competitive differentiators is our strategic partnerships with enterprise software companies and system integrators. Under our partnerships with enterprise software vendors, the partner may resell or, in some instances, embed or otherwise utilize our software with their products under limited use licenses for a license or royalty fee. Enterprise software vendors with whom we have relationships include American Management Systems (AMS), Hewlett-Packard Company, Informatica, i2 Technologies, Microsoft, Peoplesoft and Siebel Systems. We believe our systems integrator and enterprise software partners influenced, directly or indirectly, a significant portion of our license revenue during our quarters ended June 30, 2004 and 2003, and we expect this influence to continue in future periods. Under certain partnership arrangements, we may share license fees derived from joint selling opportunities with our partner. In systems integrator and 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 from the joint customer of license fees is received.

Critical Accounting Policies and Estimates

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

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

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 in the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2004 for a more comprehensive discussion of our revenue recognition policies. Judgments we make regarding these items, including collection risk, can materially impact the timing of recognition of license revenue.

     Policies related to revenue recognition require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. These sources may publish new authoritative guidance which might impact current revenue recognition policies. We continue to evaluate our revenue recognition policies as new authoritative interpretations and guidance are published, and where appropriate, may modify our revenue recognition policies. Application of our revenue recognition policy requires a review of our license and professional services agreements with customers and may require management to exercise judgment in evaluating whether delivery has occurred, payments are fixed and determinable, collection is probable, and where applicable, if vendor-specific

objective evidence of fair value exists for undelivered elements of the contract. In the event judgment in the application of our revenue recognition policies is incorrect, the revenue recognized by webMethods could be impacted.

Allowance for Doubtful Accounts

     We maintain allowances for doubtful accounts for estimated losses which may result from the inability of our customers to make required payments to us. These allowances are established through analysis of the credit-worthiness of each customer with a receivable balance, determined by credit reports from third parties, published or publicly available financial information, customer-specific experience including payment practices and history, inquiries, and other financial information from our customers. The use of different estimates or assumptions could produce materially different allowance balances. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. At June 30, 2004, and March 31, 2004, the allowance for doubtful accounts was $2,001,000 and $2,103,000 respectively.

Business Combinations

     We are required to allocate the purchase price of acquired companies to the tangible and intangible assets acquired, liabilities assumed, and in-process research and development (IPR&D) acquired 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 businesses. 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, or as events occur or circumstances change, 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 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 12 in the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2004 for more comprehensive information).

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.

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 and Related Charges

     We have recorded restructuring costs to align our cost structure with changing market conditions. These restructuring plans resulted in a reduction in headcount and 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 on 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.

Litigation and Contingencies

     We are subject to the possibility of various loss contingencies arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted.

RESULTS OF OPERATIONS

     The following table summarizes the results of our operations for the fiscal quarters ended June 30, 2004 and 2003 (all percentages are calculated using the underlying data in thousands):

     Our net loss of $10.8 million for the quarter ended June 30, 2004 increased by $4.0 million from a net loss of $6.8 million in the quarter ended June 30, 2003. The increase in net loss was due primarily to a $7.6 million decrease in license revenue in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003. That decrease in license revenue was partially offset by a $4.0 million increase in professional services revenue and a $2.2 million increase in maintenance revenue in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003. In addition, we decreased our operating expenses by $1.0 million, or approximately 3%, in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003.

Revenue

     The following table summarizes our revenue for the fiscal quarters ended June 30, 2004 and 2003:

     The following table summarizes the Company’s net revenue by geographic region for the fiscal quarters ended June 30, 2004 and 2003:

     Total revenue decreased to $41.8 million for the quarter ended June 30, 2004 from $43.2 million for the quarter ended June 30, 2003. The decrease in total revenue was due primarily to a $7.6 million decrease in license revenue for the quarter ended June 30, 2004 from the same period in the prior year, which was partially offset by an increase of $4.0 million in professional services revenue and an increase of $2.2 million in maintenance revenue in the quarter ended June 30, 2004 from the same quarter in the prior year.

     In the quarter ended June 30, 2004, revenue from the Americas increased 0.9% to $25.6 million from $25.3 million in the quarter ended June 30, 2003. International revenue decreased from $17.9 million in the quarter ended June 30, 2003 to $16.3 million in the quarter ended June 30, 2004. This decrease was partially offset by a $1.2 million favorable foreign currency impact. International revenue accounted for 39% of our total revenue in the quarter ended June 30, 2004, as compared to 41% in the quarter ended June 30, 2003.

     We had unexpectedly low license revenue in the quarter ended June 30, 2004, as license revenue decreased by 35% to $14.2 million from $21.8 million in the quarter ended June 30, 2003. During the June 2004 quarter, many enterprises unexpectedly became more cautious in their enterprise software spending. They subjected their proposed information technology purchases to rigorous internal reviews and approvals or requests for contract contingencies, which often resulted in longer sales cycles, the postponement of information technology projects, customers placing smaller orders, or difficulty in closing large deals. We did not close a number of expected opportunities we were working on near the end of the June 2004 quarter, and lower closure rates of large transactions near the end of June 2004 across almost every geographical region contributed significantly to our decrease in license revenue in the June 2004 quarter. We believe that prospects exhibited an unexpected degree of cautiousness during the June 2004 quarter, with greater involvement of their procurement departments and greater demands for various contractual contingencies unacceptable to us, which extended or delayed anticipated closure of license transactions. We also had occasional sales execution or forecasting issues that contributed to license transactions not closing in the June 2004 quarter as we anticipated.

     Professional services revenue increased 45% to $12.9 million in the quarter ended June 30, 2004 from $8.9 million in the quarter ended June 30, 2003. This increase in professional services revenue was primarily attributable to increased billable hours.

     Maintenance revenue increased 18% to $14.8 million in the quarter ended June 30, 2004 from $12.6 million in the quarter ended June 30, 2003. This increase was due primarily to the increase in the number of copies of our software licensed to customers and the cumulative effect of agreements for post-contract maintenance and support, which are recognized as revenue ratably over the term of the agreement.

Gross Profit

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

     Total gross profit, excluding stock based compensation, decreased to 63% in the quarter ended June 30, 2004 from 72% in the quarter ended June 30, 2003. This decrease was due primarily to a decrease in license revenue, as well as an increase in our cost of licenses and an increase in the cost of professional services and maintenance due principally to increased subcontractor costs.

     Our cost of license revenue in the June 2003 quarter consisted primarily of royalties for products embedded in our software licensed from third parties. Because we acquired certain technology in fiscal 2004, our cost of license revenue in the June 2004 quarter also included a charge for amortization of intangibles in the amount of $599,000. Our gross profit on license revenue was 91% and 98% in the quarters ended June 30, 2004 and 2003, respectively. The decrease in license gross profit was due to a decrease in license revenue and an increase in the fees we paid for third-party software embedded in or licensed with our software products and the amortization of intangibles.

     Our cost of professional services and maintenance consists primarily of costs related to internal professional services and support personnel, and subcontractors hired to provide implementation and support services. Our gross profit on maintenance and services, excluding stock based compensation, was approximately 49% and 46% in the quarters ended June 30, 2004 and 2003, respectively.

Operating Expenses

     The following table presents certain information regarding the Company’s operating expenses during the fiscal quarters ended June 30, 2004 and 2003:

*

Excludes stock based compensation and warrant charge, as applicable.

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

as applicable. In the quarter ended June 30, 2004, our operating expenses, excluding stock based compensation and warrant charge, decreased $1.0 million from $38.1 million in the quarter ended June 30, 2003, to $37.1 million despite a $850,000 unfavorable foreign currency impact.

     Sales and marketing expense, excluding stock based compensation and warrant charge, was 50% and 52% of total revenue in the quarters ended June 30, 2004 and 2003, respectively. In the quarter ended June 30, 2004, sales and marketing expense decreased to $21.0 million from $22.5 million in the quarter ended June 30, 2003, excluding stock based compensation and warrant charge. This decrease was primarily due to a decrease in the number of sales and marketing employees, commission expense, sales assistance fees and marketing programs expense. In addition, during the quarter ended June 30, 2004, sales and marketing expenses reflected a $728,000 unfavorable foreign currency impact.

     Research and development expense was $11.1 million and $11.2 million in the quarters ended June 30, 2004 and 2003, respectively, which represents 26% of total revenue. In the quarter ended June 30, 2004, research and development expense decreased $150,000 from research and development expense in the quarter ended June 30, 2003 primarily due to a decrease in the use of external consultants.

     General and administrative expense, excluding stock based compensation, as a percentage of total revenue was approximately 12% and 10% for the quarters ended June 30, 2004 and 2003, respectively. In the quarter ended June 30, 2004, general and administrative expense, excluding stock based compensation, increased $650,000 from the quarter ended June 30, 2003, to $5.1 million. This increase is primarily due to an increase in consulting fees associated with Sarbanes-Oxley Act compliance initiatives and an increase in bad debt expense. During the quarter ended June 30, 2004, general and administrative expenses reflected a $105,000 unfavorable foreign currency impact.

     Stock based compensation and warrant charge was $661,000 and $721,000 in the quarters ended June 30, 2004 and 2003, respectively, of which $22,000 was included in cost of sales for the quarter ended June 30, 2003. Deferred stock based compensation and warrant charge was recorded for the following transactions:

	(i)		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)		An OEM/Reseller agreement we entered into with i2 Technologies (i2) in March 2001 under which we issued a warrant which, as amended, permits i2 to purchase 710,000 shares of webMethods, Inc. 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 is amortized over the vesting period of the applicable equity arrangement and is shown by expense category.

Interest Income

     Interest income decreased by approximately $454,000, or 45%, to $553,000 for the quarter ended June 30, 2004 from $1.0 million for the quarter ended June 30, 2003. This decrease was primarily attributable to decreased cash balances and lower interest rates on commercial paper, corporate bonds and money market funds in the quarter ended June 30, 2004, compared to those in the same period in the prior year.

Interest Expense

     Interest expense is primarily due to equipment leasing arrangements in the Americas. During the quarter ended June 30, 2004, interest expense decreased by approximately $62,000, or 70%, to $27,000 from $89,000 for the quarter ended June 30, 2003. This decrease is primarily due to the completion of previously established leases.

Other Income

     Other income includes gains and losses on foreign currency transactions. During the quarter ended June 30, 2004, our foreign currency transaction gain increased $96,000, or 600%, to $112,000 from $16,000 for the quarter ended June 30, 2003.

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 probable.

     As of March 31, 2004, we had net operating loss carry-forwards of approximately $276.9 million. These net operating loss carry-forwards are available to reduce future taxable income and begin to expire in fiscal year 2007. Under the provisions of the Internal Revenue Code, certain substantial changes in our ownership have limited the amount of net operating loss carry-forwards that could be utilized annually in the future to offset taxable income.

     For the quarter ended June 30, 2004, our operations in Japan incurred minimum tax expense of $21,000 that the Company can not off-set by utilizing its net operating losses generated in prior years.

LIQUIDITY AND CAPITAL RESOURCES

     Historically we have financed our operations and met our capital requirements though the sales of equity securities. Our liquidity and financial position at June 30, 2004, showed a 28% decrease in our cash and investments, to $147.3 million and a 31% decrease in our working capital, to $109.7 million from our positions at June 30, 2003. The decrease in working capital is primarily due to approximately $32.4 million of cash payments related to the acquisitions of The Mind Electric, Inc., The Dante Group and the portal solution previously known as DataChannel in October 2003. The decrease in working capital also reflects a decrease in our current liabilities offset by an increase in accounts receivable balances at June 30, 2004, as compared to June 30, 2003.

     Net cash used in operating activities was $7.2 million for the quarter ended June 30, 2004, and net cash provided by operating activities was $3.3 million for the quarter ended June 30, 2003. The increase in cash used in operating activities during the quarter ended June 30, 2004, compared to quarter ended June 30, 2003, was due primarily to a larger net loss and changes in accounts receivable balances, accounts payable balances and accrued salaries and commissions.

     Net cash used in investing activities was $5.5 million for the quarter ended June 30, 2004, and net cash provided by investing activities was $14.8 million for the quarter ended June 30, 2003. The increase in cash used by investing activities was primarily due to the purchase of $3.8 million of marketable securities for the quarter ended June 30, 2004 as compared to the sale of $14.7 million of marketable securities for the quarter ended June 30, 2003. Capital expenditures were $1.6 million and $890,000 in the quarters ended June 30, 2004 and 2003, respectively. Capital expenditures consisted of purchases of operating resources to manage operations, including computer hardware and software, office furniture and equipment and leasehold improvements. We generally fund capital expenditures through capital leases and the use of working capital. Additionally, for the quarter ended June 30, 2003, we received $1.0 million in proceeds from the sale of a substantial portion of an investment in a private company.

     Net cash provided by financing activities was $1.5 million and $31,000 in the quarters ended June 30, 2004 and 2003, respectively. These cash flows primarily reflect net cash proceeds from exercises of stock options and Employee Stock Purchase Plan common stock issuances offset by payments on capital leases in the quarters ended June 30, 2004 and 2003. Net cash proceeds from exercises of stock options were $634,000 and $262,000 in quarters ended June 30, 2004 and 2003 respectively. Net cash proceeds from ESPP common stock issuances were $1.2 million in the quarters ended June 30, 2004 and 2003. Payments on capital leases were $311,000 and $1.5 million in quarters ended June 30, 2004 and 2003, respectively.

     We have a line of credit to borrow up to a maximum principal amount of $20,000,000 with a maturity date of October 10, 2004, which we expect to renew. Any borrowings under this line bear interest at the bank’s prime rate per annum. As of June 30, 2004, we had not borrowed against this line of credit. In connection with the line of credit, we have a letter of credit totaling $115,000 related to an office lease. In connection with leasing of replacement office space, we will be required to supply additional letters of credit that are expected to total $2.5 million. 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. We are not a party to any agreements with, or commitments to, any special-purpose entities that would constitute off-balance sheet financing.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

     You should consider the following factors when evaluating our statements in this report and elsewhere. We are subject to risks in addition to those we describe 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, Inc. common stock.

Unanticipated fluctuations in our quarterly revenue or operating results, or failure to return to and maintain profitability, could significantly affect the price of webMethods, Inc. common stock.

     We believe that quarter-to-quarter or year-to-year comparisons of our financial results are not necessarily meaningful indicators of our future revenue or operating results and should not be relied on as an indication of our future performance. If our quarterly or annual revenue or operating results fail to meet the guidance we provide publicly or the expectations of investors or analysts, that could have a material adverse effect on the market price of webMethods, Inc. common stock. 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, the timing and terms of large transactions with customers, competitive pressures, our ability to execute on our business plans, the amount and timing of operating costs, delays in the availability of new products or new releases of existing products and changes that we may make in our business, operations and infrastructure. In addition, economic conditions and other events beyond our control, such as economic uncertainties, geopolitical developments or uncertainties, travel limitations, infectious outbreaks like SARS, terrorist acts and other major, unanticipated events may have significant negative impact on our quarterly operating results and delay our ability to return to and maintain profitability on a basis determined in accordance with accounting principles generally accepted in the United States (GAAP). Further, the expensing of stock options in the future, the costs of compliance with the Sarbanes-Oxley Act and other legal and compliance requirements could add significant costs that may impede or delay our ability to return to and maintain profitability on a GAAP basis. If our quarterly revenue or operating results are adversely impacted, that could have a material adverse effect on the market price of webMethods, Inc. common stock.

     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 or our operating costs increase 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 guidance we provide publicly or expectations of investors or analysts. It is possible that our revenue or operating results in the future may be below the guidance we provide publicly and the expectations of investors or analysts and, as a result, the market price of webMethods, Inc. common stock may fall significantly. 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 June 30, 2004, the closing price of webMethods, Inc. stock on the Nasdaq National Market has ranged from a high of $308.06 to a low of $4.32.

Growth of our sales may slow from time to time, causing our quarterly operating results to fluctuate and possibly resulting in significant volatility in the market price of webMethods, Inc. common stock.

     Due to customer demand, economic conditions, the timing and terms of large transactions with customers, competitive pressures, our ability to execute on our business plan, changes that we may make in our business or operations, 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, and may be impacted by the annual nature of our sales compensation plans.

     We also may experience delays or declines in expected revenue due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers, purchasing practices and requirements of prospective customers, including contract provisions or contingencies they may request, changes in demand for our software and services, changes that we may make in our business or operations, economic uncertainties, geopolitical developments or uncertainties, travel limitations, infectious outbreaks like SARS, terrorist acts or other major unanticipated events. These periods of slower or no growth may lead to lower revenue, which could cause fluctuations in our quarterly operating results. In addition, variations in sales cycles may have an impact on the timing of our revenue, which in turn could cause our quarterly operating results to fluctuate. To successfully sell our software and services, we generally must educate our potential customers regarding their use and benefits, which can require significant time and resources. Any 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 significant volatility in the market price of webMethods, Inc. common stock.

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 our forecasts of operating results.

     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 acquired several businesses and technologies with limited operating histories. During much of our history, we have sustained losses from operations. For a number of reasons described in other factors listed here, we may not be able to achieve our anticipated revenue growth, and control costs of operations, to achieve our forecasts of operating results, including returning to and maintaining profitability on a GAAP basis. That situation could have a material adverse effect on the market price of webMethods common stock. If we do not generate sufficient revenue to achieve and maintain income from 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 returning to and maintaining profitability and the anticipated or forecasted results of operations could be reduced, which, in turn, could have a material adverse effect on the market price of webMethods common stock.

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

     The markets for business integration solutions, Service-Oriented Architecture capabilities, Business Activity Monitoring and Business Process Management solutions and Composite Application framework capabilities are rapidly changing and intensely competitive. There are a variety of methods available to integrate software applications, monitor and optimize business processes and workflows, provide Service-Oriented Architectures, enable Web services and provide customers the capabilities to run, manage and optimize their enterprise. 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 Service-Oriented Architecture technology, our Enterprise Services Platform solution, our Business Process Management solution, our Business Activity Monitoring solution, our Composite Application Framework or other solutions we offer or have announced. If 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 that develop their own integration software or Web services technology; software vendors offering business integration software, Service-Oriented Architecture technology, Web services capabilities, Business Process Management software and Business Activity Monitoring software; electronic data interchange vendors; vendors of proprietary enterprise application integration; vendors of portal products; and application server vendors. We also face competition from providers of various technologies to enable Web services. Further, we face competition for some aspects of our software and service offerings from major system integrators, both independently and in conjunction with corporate in-house information technology departments, which have traditionally been the prevalent resource for application integration. In addition, application software vendors with whom we currently have or have had strategic relationships sometimes offer competitive solutions or become competitors. Some of our competitors or potential competitors may have more experience developing technologies or solutions competitive with ours, 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 solutions, that achieve greater customer acceptance or that have significantly improved functionality or performance as compared to our existing solutions and future software and services. In addition, negotiating and maintaining favorable customer and strategic relationships is critical to our business. Our competitors may be able to negotiate strategic relationships on more favorable terms than we are able to negotiate. Many of our competitors may also have well-established relationships with our existing and prospective customers. Increased competition may result in reduced margins, loss of sales, decreased market share or longer sales cycles or sales processes involving more extensive demonstrations of product capabilities, 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 promote and implement our software and, if these relationships diminish or terminate, we may lose important deals and marketing opportunities.

     We have established strategic relationships with enterprise software vendors and system integration partners. These strategic partners provide us with important sales and marketing opportunities, create opportunities to license our solutions, upsell our products to customers already using license-limited versions of our software embedded in their enterprise products, and greatly increase our implementation capabilities. We also have similar relationships with resellers, distributors and other technology leaders. During our fiscal year 2004 and the first quarter of our fiscal year 2005, our enterprise software and systems integrator partners directly or indirectly influenced a significant portion of our license revenue, and we expect that leverage to continue in future periods. If our relationships with our strategic business partners diminished or 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, our business may suffer and our financial results could be adversely impacted. Our partners often are not required to market or promote our software and generally are not restricted from working with vendors of competing software or

solutions or offering their own solutions providing similar capabilities. Accordingly, our success will depend on their willingness and ability to devote sufficient resources and efforts to marketing our software and solutions rather than the products of competitors or that they offer themselves. 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, our operating results and the market price of webMethods, Inc. common stock.

Recent and future acquisitions of companies or technologies may result in disruptions to our business, dilution or other adverse effects on future financial results or the distraction of our management.

     In October 2003, we acquired businesses and technologies, and we may acquire or make investments in other complementary businesses and technologies in the future. Although the October 2003 acquisitions produced results at or above our expectations on a cumulative basis through the first quarter of our fiscal year 2005, we may not be able to realize benefits or results in the future that we expect to achieve from those businesses and technologies.

     We may make investments in, or acquisitions of, technology, products or companies in the future to maintain or improve our competitive position. We may not be able to identify 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 potential future acquisitions, we may not be able to realize future benefits we expected to achieve at the time of entering into the transaction, or our recognition of those benefits may be delayed. 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 stockholders.

Treating stock options and employee stock purchase plan participation as a compensation expense could significantly impair our ability to return to and maintain profitability.

     The Financial Accounting Standards Board has proposed requiring companies to record compensation expense regarding stock options and participation in employee stock purchase plans. We grant stock options to our employees, officers and directors and we administer an employee stock purchase plan (ESPP). Information on our stock option plan and ESPP, including the shares reserved for issuance under those plans, the terms of options granted, the terms of ESPP participation, and the shares subject to outstanding stock options, is included in Note 14 of the Notes to Consolidated Financial Statements of webMethods, Inc. included in our Annual Report on Form 10-K for our fiscal year ended March 31, 2004. If we choose, or are required, to record an expense for our stock-based compensation plans, we could incur a significant compensation expense, and any such expense could significantly impair our ability to return to and maintain profitability on a GAAP basis. That impact on our ability to return to and maintain profitability on a GAAP basis could have a material adverse effect on the market price of webMethods, Inc. common stock.

Our operating results may decline and our customers may become dissatisfied if we do not provide professional services to implement our solutions 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 product implementation, training and other professional consulting services, and we believe our strong focus on ensuring that our software is successfully put into production is a strong competitive advantage and differentiator. 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 to implement our solutions of if we are unable to establish and maintain relationships with third-party implementation providers.

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.

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 and solutions require 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 use 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 relatively limited experience in marketing, selling and supporting our software and services in certain 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, business practices, 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.

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

     We expect that the rapid evolution of business integration software, Service-Oriented Architecture technology, Business Process Management solutions, Business Activity Monitoring solutions, Composite Application technologies, and related standards and 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 and solutions to remain competitive. Our software and solutions could become obsolete, unmarketable or less desirable to prospective customers if we are unable to adapt to new technologies or standards. Serious defects may be found during the period immediately following introduction of new software or enhancements to existing software or in product implementations in varied information technology environments. Internal quality assurance testing and customer testing may reveal product performance issues or desirable feature enhancements that could lead us to reallocate product development resources or postpone the release of new versions of our software. The reallocation of resources associated or any postponement could cause delays in the development and release of future enhancements to our currently available software, could require significant additional professional services work to address operational issues 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 partners and 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 partners and 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 or ceases to demonstrate technology leadership, we may have to increase our product development costs and divert our product development resources to address the problems. In addition, because our customers and certain partners depend on our software for their critical systems and business functions, any interruptions in operation of our software or solutions could cause our customers and certain partners to initiate warranty or product liability suits against us.

Because our software could interfere with the operations of our partners’ and customers’ other software applications, we may be

subject to potential product liability and warranty claims by these partners and customers, which may be time consuming, costly to defend and may not be adequately covered by insurance.

     Our software enables customers’ and certain partners’ software applications to provide Web services, or to integrate with networks and software applications, and is often used for mission-critical functions or applications. Errors, defects, other performance problems in our software or failure to provide technical support could result in financial or other damages to our partners and customers. Partners and 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 and solutions to perform to partners’ and customers’ 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 use of our software to enable partners’ and customers’ software applications to provide Web services, and the integration of our software with our partners’ and customers’ networks and software applications, increase the risk that a partner or 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 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, acquisition, 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; developing new software or services; or responding 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.

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

     We cannot be certain that our software and the services do not infringe issued patents, copyrights, trademarks or other intellectual property rights of third parties. Litigation regarding intellectual property rights is common in the software industry, and we have been subject to, and may be increasingly subject to, legal proceedings and claims from time to time, including claims of alleged infringement of intellectual property rights of third parties by us or our licensees concerning their use of our software products, 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, and may bring in the future, claims of infringement against us or our licensees. Because our software is integrated with our customers’ networks and business processes, as well as other software applications, third parties may bring claims of infringement against us, as well as our customers and other software suppliers, if the cause of the alleged infringement cannot easily be determined. We have agreed, and may agree in the future, to indemnify certain of our customers against claims that our software infringes upon the intellectual property rights of others. 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. Five of our customers have been subject to such claims and litigation, and we or other customers may in the future be subject to additional claims and litigation. We have settled one such claim and may in the future settle any other such claims with which we may be involved, 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. Our current insurance programs do not cover claims of patent infringement.

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 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 and consumer goods manufacturing and retail 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 stockholder 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 stockholder rights plan and declared a dividend distribution of one right for each outstanding share of webMethods, Inc. 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, Inc. 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 March 31, 2004, 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, Canada, United Kingdom, France, Germany, Japan, the Netherlands, South Korea, Hong Kong, Malaysia and Singapore. Transaction gains or losses have not been significant in the past, and there is no hedging activity on foreign currencies. We would not experience a material foreign exchange loss based on a hypothetical 10% adverse change in the price of the euro, Great Britain pound, Singapore dollar, Australian dollar, Malaysian ringgit, South Korean won, Canadian dollar or Japanese yen against the U.S. dollar. Consequently, we do not expect that a reduction in the value of such accounts denominated in foreign currencies resulting from even a sudden or significant fluctuation in foreign exchange rates would have a direct material impact on our financial position, results of operations or cash flows.

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

ITEM 4. CONTROLS AND PROCEDURES

     As of June 30, 2004, 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 Rule 13a-15 promulgated under the Securities Exchange Act of 1934, as amended. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective at the reasonable assurance level 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. While webMethods continues the process of documenting, testing and enhancing, where necessary or appropriate, its internal controls over financial reporting, there have been no significant changes in internal controls, or in factors that could significantly affect internal controls, during the quarter ended June 30, 2004 that have materially affected, or are 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 (IPO) and the managing underwriters of our initial public offering as defendants. The amended complaint alleges, among other things, that underwriters of webMethods’ IPO solicited and received excessive commissions and demanded tie-in arrangements from the underwriters’ customers in connection with their allocation of shares in webMethods’ IPO, and that those activities allegedly undertaken by the underwriters of webMethods’ IPO were not disclosed in the registration statement and final prospectus for webMethods’ IPO or disclosed to the public after webMethods’ IPO. The amended complaint also alleges that false analysts’ reports were issued by the underwriters. The amended complaint seeks unspecified damages on behalf of a purported class of purchasers of webMethods, Inc. 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). Claims against webMethods’ executive officer defendants have been dismissed without prejudice. webMethods has considered and conditionally agreed to enter into a proposed settlement with representatives of the plaintiffs in the consolidated proceeding. Under the proposed settlement, the plaintiffs would dismiss and release their claims against webMethods in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuers in the consolidated action and assignment or surrender to the plaintiffs by the settling issuers of certain claims that may be held against the underwriter defendants. We believe that any material liability on behalf of webMethods or its executive officers that may accrue under that settlement offer would be covered by our insurance policies.

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

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

(a)

Exhibits.

     (b) Reports on Form 8-K. The following reports on Form 8-K have been filed by webMethods, Inc. since the beginning of its fiscal quarter on April 1, 2004:

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.