UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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, $0.01 par value

Preferred Stock Purchase Rights

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

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

      As of February 10, 2005, there were outstanding 53,317,777 shares of the registrant’s Common Stock.

WEBMETHODS, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED DECEMBER 31, 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)

      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 Amendment No. 2 to 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 and nine months ended December 31, 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.

      On February 3, 2005, the Company issued a press release and thereafter filed a Form 8-K announcing that the Company was restating its financial statements for fiscal year 2004 (ended March 31, 2004), as well as quarterly financial statements for each of the three interim quarterly reports in that fiscal year and for the three months ended June 30, 2004. That announcement related primarily to the recently completed independent investigation conducted by the Company’s Audit Committee into certain transactions of the Company’s Japanese subsidiary.

      As a result of the investigation, the Company’s Audit Committee concluded that improper activities of certain employees of the Japanese subsidiary caused the Company to misstate revenue and expenses for the year ended March 31, 2004 and certain quarters therein and the three months ended June 30, 2004, as well as misstate accounts receivable, deferred revenue, debt and certain other items attributable to the operations of the Japanese subsidiary. The Audit Committee’s investigation found that the improper activities included, among other things, engaging in improper licensing and professional services transactions and misrepresenting the transactions to the Company’s management; causing the Japanese subsidiary to engage in undisclosed and unauthorized borrowings; failing to record expenses and recording improper expenses; and creating false documents in support of improper transactions. The Audit Committee also determined that those employees of the Japanese subsidiary acted to conceal their improper activities from webMethods’ management.

      The adjustments to the Company’s financial statements in the restatements fall into five general categories: (i) adjustments to license, professional services and maintenance revenue relating to improper activities of certain employees of the Japanese subsidiary; (ii) adjustments to deferred revenue with respect to certain of those revenue items that should have been deferred and recognized as revenue in subsequent periods; (iii) adjustments to properly record expenses of the Japanese subsidiary in the appropriate period; (iv) adjustments to debt (excluding the reclassification of interest expense, which was nominal) and accounts receivable as a result of certain unauthorized borrowings by the Japanese subsidiary that were improperly recorded by it as collections of receivables; and (v) elimination of a provision for tax expense based upon estimates of the taxable income of the Company’s Japanese subsidiary.

      As a result of the foregoing, the Company’s consolidated financial statements for the three- and nine-month periods ended December 31, 2003 and the Company’s Consolidated Balance Sheet at March 31, 2004 have been restated from amounts previously reported. The accompanying consolidated financial data presents the Company’s restated Condensed Consolidated Statements of Operations for the three and nine

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

2.     Restatements — (Continued)

months ended December 31, 2003 and the restated balance sheet items as of March 31, 2004 on a comparative basis showing the amounts as originally reported and as restated.

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

2.     Restatements — (Continued)

      Consequently, the effects of the restatements have been reflected in Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-Q.

      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, 2004 and 2003:

      The calculation of the Company’s net loss per share on a basic and diluted basis 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 496,149 and 871,056 shares for the quarters ended December 31, 2004 and 2003, respectively, have been excluded from the net loss per share calculation because their effect would be anti-dilutive. Employee stock options and a non-employee warrant exercisable for 480,765 and 829,031 shares for the nine months ended December 31, 2004 and 2003, respectively, have been excluded from the net loss per share calculation because their effect would be anti-dilutive.

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

      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 areas is as follows:

      The Company has recorded restructuring and related charges to align its cost structure with changing market conditions. During the nine months ended December 31, 2004, the Company recorded a restructuring charge of $3.0 million due to a reduction in headcount and a $256,000 adjustment to previously recorded restructuring charges due to a revision in estimated severance and related benefits, resulting in a net restructuring charge of $2.8 million.

      The Company has previously recorded restructuring and related charges due to reductions in headcount and consolidation of offices. The cumulative amount of restructuring and related charges for the period September 30, 2001 through March 31, 2004, was $13.3 million.

      As of December 31, 2004 and March 31, 2004, respectively, $2.0 million and $3.1 million of restructuring and related charges remained unpaid. The December 31, 2004, balance includes $1.7 million relating to rent on excess facilities that is to be paid over the remaining rental periods and $220,000 relating to severance and other related benefits that is to be paid out according to the severance agreements.

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

      The following table sets forth a summary of total restructuring and related charges, payments made against those charges and the remaining liabilities as of December 31, 2004:

      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 this 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. In September 2004, the Company recorded an other-than-temporary decline in value of $1,057,000 in this equity investment. The third party has been a business partner of the Company. As of December 31, 2004 and March 31, 2004, the carrying value of the investment in this third party was $0 and $1,057,000, respectively.

      The Company has a line of credit agreement with a bank to borrow up to a maximum principal amount of $20,000,000 with a maturity date of April 30, 2005. Borrowings under this note are limited to 80% of eligible accounts receivable. Interest is payable on any unpaid principal balance at the bank’s prime rate. The agreement includes restrictive covenants which require the Company to maintain, among other things, a ratio of quick assets to current liabilities, excluding deferred revenue of at least 1.5 to 1.0 and a quarterly revenue covenant such that total revenue for each fiscal quarter must be the greater of $35,000,000 or 85% of the average total revenue for the immediately preceding four fiscal quarters. As of December 31, 2004, the Company had not borrowed against this line of credit. In connection with the line of credit agreement, the Company has obtained letters of credit totaling approximately $1.1 million related to office leases.

      In March 2004, the Japanese subsidiary borrowed $2.6 million from a reseller, which was repaid in May 2004. The Company’s Japanese subsidiary had no borrowings outstanding as of December 31, 2004.

      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, revenue from specific geographic regions income or loss, earnings or loss per share, return to profitability on a pro-forma or GAAP basis, capital expenditures, costs of investigations, legal compliance efforts and modification, testing and remediation of internal controls, 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 the Company 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 or specific geographic regions, implementation and effect of sales and marketing initiatives by the Company, 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, the Company’s 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 negatives 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 Amendment No. 2 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.

RECENT DEVELOPMENTS

Restatement

      On February 3, 2005, the Company issued a press release and thereafter filed a Form 8-K announcing that the Company was restating its financial statements for fiscal year 2004 (ended March 31, 2004), as well as quarterly financial statements for each of the three interim quarterly reports in that fiscal year and for the three months ended June 30, 2004. That announcement related primarily to the recently completed independent investigation conducted by the Company’s Audit Committee into certain transactions of the Company’s Japanese subsidiary.

      As a result of the investigation, the Company’s Audit Committee concluded that improper activities of certain employees of the Japanese subsidiary caused the Company to misstate revenue and expenses for the year ended March 31, 2004 and certain quarters therein and the three months ended June 30, 2004, as well as misstate accounts receivable, deferred revenue, debt and certain other items attributable to the operations of the Japanese subsidiary. The Audit Committee’s investigation found that the improper

activities included, among other things, engaging in improper licensing and professional services transactions and misrepresenting the transactions to the Company’s management; causing the Japanese subsidiary to engage in undisclosed and unauthorized borrowings; failing to record expenses and recording improper expenses; and creating false documents in support of improper transactions. The Audit Committee also determined that those employees of the Japanese subsidiary acted to conceal their improper activities from webMethods’ management.

      The adjustments to the Company’s financial statements in the restatements fall into five general categories: (i) adjustments to license, professional services and maintenance revenue relating to improper activities of certain employees of the Japanese subsidiary; (ii) adjustments to deferred revenue with respect to certain of those revenue items that should have been deferred and recognized as revenue in subsequent periods; (iii) adjustments to properly record expenses of the Japanese subsidiary in the appropriate period; (iv) adjustments to debt (excluding the reclassification of interest expense, which was nominal) and accounts receivable as a result of certain unauthorized borrowings by the Japanese subsidiary that were improperly recorded by it as collections of receivables; and (v) elimination of a provision for tax expense based upon estimates of the taxable income of the Company’s Japanese subsidiary.

      As a result of the foregoing, the Company’s consolidated financial statements for the three- and nine-month periods ended December 31, 2003 and the Company’s Consolidated Balance Sheet at March 31, 2004 have been restated from amounts previously reported. None of the adjustments described above have any impact on cash balances for any period. However, our consolidated statements of cash flows for the nine-months ended December 31, 2003 have been restated to reflect the restated net loss and revisions to certain balance sheet accounts.

      Consequently, the effects of the restatements have been reflected in Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-Q.

OVERVIEW

Background

      We are a leading provider of business integration software enabling customers to integrate, assemble and optimize their available information technology assets to drive business process productivity. Our software products and related services give organizations the ability, seamlessly and in real-time, to integrate disparate information resources to create a unified, homogenous view of those resources. By effectively eliminating the disparity between the underlying systems, our customers are better able to connect their customers, vendors and business partners with our customer’s organization and their employees. The result is streamlined operational systems, increased visibility into critical data and business processes, and better connectivity to the information technology assets of our customers’ organizations, both internally and externally. Our customers’ organizations benefit by increasing the value from their information technology assets, by improving their ability to quickly respond to external business drivers, and by establishing the proper levels of control and governance over critical business processes.

      We license our software and provide services to Global 2000 customers through our direct sales force augmented by system integrators, application software partners and distributors. In Japan and the Asia Pacific region and, to a lesser extent, in Europe and the Americas, we also license our software through resellers. We license our software to customers primarily on a perpetual basis. As of December 31, 2004, we had over 1,250 customers, compared to approximately 1,000 customers as of December 31, 2003.

      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 2005, our global customer services group reported and documented approximately 165 separate production events as compared to over 130 such events reported and documented during the quarter ended December 31, 2003. 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 business integration projects and serve as a reference customer for us in our future sales efforts.

      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, Inc. was a provider of business activity monitoring software. The aggregate purchase price for these three acquisitions was approximately $32.4 million in cash.

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 3 of the Consolidated Financial Statements included in the Company’s Amendment No. 2 to 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 us 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’s 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.

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 13 in the Consolidated Financial Statements included in the Company’s Amendment No. 2 to 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 three and nine months ended December 31, 2004 and 2003 (all percentages are calculated using the underlying data in thousands):

      Our net income for the three months ended December 31, 2004 was $48,000 as compared to a net loss of $11.2 million for the three months ended December 31, 2003. This improvement was due primarily to a $4.9 million increase in total revenue and a $6.0 million decrease in total operating expenses in the three months ended December 31, 2004 compared to the same period in the prior year. The decrease in total operating expenses was due primarily to a $4.3 million in process research and development charge and a $1.3 million restructuring charge included in the three months ended December 31, 2003.

      Our net loss of $14.9 million for the nine months ended December 31, 2004 decreased by approximately $9.5 million from a net loss of approximately $24.4 million in the nine months ended December 31, 2003. The decrease in net loss was due primarily to the following changes in the nine months ended December 31, 2004 as compared to the prior year period: an $11.0 million increase in total revenue and a $5.4 million decrease in total operating expenses which was offset by a $5.3 million increase

in total cost of revenue and a $1.1 million impairment of an equity investment in a private company equity.

Revenue

      The following table summarizes our revenue for the three and nine months ended December 31, 2004 and 2003:

      The following table summarizes our net revenue by geographic region for the three and nine months ended December 31, 2004 and 2003:

      Total revenue for the three months ended December 31, 2004 increased by 10% compared to the same period in the prior year due to increases in license, professional services and maintenance revenue. Total revenue for the nine months ended December 31, 2004 increased by 8% due to increases in professional services and maintenance revenue, offset by a decrease in license revenue.

      License revenue for the three months ended December 31, 2004 increased by 4% as compared to the same period in the prior year despite our having fewer quota bearing sales representatives during the three months ended December 31, 2004 as compared to the same period in the prior year. This 4% increase in license revenue was due to our broader suite of software products available for sale (due to our October 2003 acquisitions of The Mind Electric, Inc., The Dante Group, Inc. and DataChannel), as well as improved sales force productivity and execution resulting from improved sales processes.

      The 4% decrease in license revenue for the nine months ended December 31, 2004 was due primarily to unexpectedly low license revenue in the three month period ended June 30, 2004. During that period, we did not close a number of expected opportunities we were working on near the end of that quarter and experienced lower closure rates of large transactions across almost every geographical region. We believe that prospective customers 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 for the three and nine month periods ended December 31, 2004 increased by 6% and 19%, respectively as compared to the same periods in the prior year. These increases

in professional services revenue levels are due primarily to an increase in billable hours recorded by our professional services staff and/or subcontractors, which is due partially to the increased demand for our professional services from our customer base.

      Maintenance revenue for the three and nine month periods ended December 31, 2004 increased by 24% and 19%, respectively as compared to the respective periods in the prior year due primarily to the increase in the number of copies of our software licensed by our customers and the cumulative effect of initial or renewed post-contract maintenance and support agreements, which are recognized ratably over the term of the agreement.

Cost of Revenue and Gross Margin

      The following table summarizes our gross margin by type of revenue, excluding stock based compensation, for the three and nine months ended December 31, 2004 and 2003:

      Total gross margin, license margin, and professional services and maintenance margin for the three months ended December 31, 2004 improved as compared to the prior year period. Gross margin for the nine months ended December 31, 2004, decreased to 69% compared to 71% in the prior year period due primarily to the decrease in license revenue as a percentage of total revenue and the increase in cost of license revenue due to the amortization of intangibles for technology acquired in October 2003, which was partially offset by an improvement in professional services and maintenance margins.

      Our cost of license revenue consists primarily of royalties for products embedded in our software which we license from third parties, and amortization of intangible related to certain technology we acquired in October 2003. The improvement of our license margin to 97% for the three months ended December 31, 2004 is due to a reduction in royalties related to a product previously embedded in our software, which we licensed from a third party, and which we have replaced with internally developed software.

      The decrease in our license margin to 95% for the nine months ended December 31, 2004 is due to the full period effect of the amortization of intangibles related to certain technology we acquired in October 2003, partially offset by a reduction in royalties related to a product previously embedded in our software, which we licensed from a third party, and which we have replaced with internally developed software.

      Our cost of professional services and maintenance revenue consists of costs related to our professional services and support personnel, as well as subcontractors we hire to provide implementation and support services. Our gross margin on professional services and maintenance revenue was 53% and 45% for each of the three months ended December 31, 2004 and 2003, respectively, and 49% and 46% for the nine months ended December 31, 2004 and 2003, respectively. These margin improvements are due primarily to increases in maintenance revenue for the three and nine months ended December 31, 2004.

Operating Expenses

      The following table presents certain information regarding our operating expenses during the three and nine months ended December 31, 2004 and 2003:

      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 and restructuring charges. For the three months ended December 31, 2004, our operating expenses, excluding stock based compensation and warrant charge, restructuring charges and in process research and development, decreased by $323,000 to $40.1 million compared to $40.4 million in the prior year period. This decrease was due primarily to our continued focus on controlling expenses. For the nine months ended December 31, 2004, our operating expenses, excluding stock based compensation and warrant charge, restructuring charges and in process research and development, decreased $2.4 million to $113.0 million from $115.3 million in the prior year period.

      For the three months ended December 31, 2004, our sales and marketing expense, excluding stock based compensation and warrant charge, decreased by $2.5 million and decreased as a percentage of revenue compared to the prior year period. The absolute dollar decrease was primarily due to lower personnel costs due to a decrease in the number of sales and marketing employees, as well as decreases in marketing program costs and lower travel costs. For the nine months ended December 31, 2004 sales and marketing expense, excluding stock based compensation and warrant charge, decreased by $5.4 million and decreased as a percent of revenue compared to the prior year period. The absolute dollar decrease was primarily due to lower personnel costs due to a decrease in the number of sales and marketing employees, as well as decreases in commission expenses, marketing program costs and travel costs. For the three and nine months ended December 31, 2004, research and development expense, excluding stock based

compensation, decreased $569,000 and $756,000, respectively, in absolute dollars and decreased as a percentage of revenue due to the increase in total revenue.

      For the three months ended December 31, 2004, general and administrative expense, excluding stock based compensation, increased by $2.8 million and increased to 13% as a percentage of revenue compared to 9% in the prior year period. For the nine months ended December 31, 2004, general and administrative expense, excluding stock based compensation, increased by $3.8 million and increased as a percentage of revenue compared to the prior year period. In both the three and nine month periods ended December 31, 2004, the increases were primarily due to an increase in accounting and legal services associated with the internal investigation of the Company’s Japanese subsidiary as discussed in Note 2 above, as well as additional personnel costs, Sarbanes-Oxley Act compliance costs and costs related to an employment matter.

      Stock based compensation and warrant charge was $2.0 million and $2.2 million during the nine months ended December 31 2004 and 2003, respectively, of which $57,000 was included in cost of sales for the nine months ended December 31, 2003. Stock based compensation and warrant charge was $661,000 and $707,000 in the three months ended December 31, 2004 and 2003, respectively, of which $12,000 was included in cost of sales for the three months ended December 31, 2003. Deferred stock based compensation and warrant charge was recorded for the following transactions:

      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 was $615,000 for the three months ended December 31, 2004 compared to $549,000 for the prior year period. For the nine months ended December 31, 2004, interest income decreased to $1.7 million compared to $2.3 million for the prior year period primarily due to decreased cash and marketable securities balances related primarily to the cash used in connection with the October 2003 acquisitions.

Interest Expense

      Interest expense is primarily due to equipment leasing arrangements in the Americas. During the three and nine months ended December 31, 2004, interest expense was $28,000 and $84,000, respectively as compared to $56,000 and $162,000, respectively for the prior year periods.

Other Expense

      Other expense is primarily due to net losses on foreign currency transactions. During the three and nine months ended December 31, 2004, we incurred other expense of $27,000 and $31,000, respectively, compared to $196,000 and $171,000 in the respective prior year periods.

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 $279.8 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.

      During the three and nine months ended December 31, 2004, our operations from foreign subsidiaries incurred tax expense of $126,000 and $195,000, respectively, that the Company cannot offset by utilizing its net operating losses generated in prior years.

LIQUIDITY AND CAPITAL RESOURCES

      As of December 31, 2004, cash and marketable securities available for sale totaled $145.9 million compared to $155.9 million as of March 31, 2004.

      Net cash used in operating activities was $7.4 million and $12.7 million for the nine months ended December 31, 2004 and 2003, respectively. The decrease in cash used in operating activities during the nine months ended December 31, 2004, compared to the nine months ended December 31, 2003, was due primarily to a $9.5 million reduction in net loss, offset by $3.5 million in net changes in non-cash expenses and charges.

      Net cash used in investing activities was $485,000 and $6.4 million for the nine months ended December 31, 2004 and 2003, respectively. During the nine months ended December 31, 2004, net cash provided from the maturity of marketable securities was $3.4 million, as compared to $26.9 million for the nine months ended December 31, 2003, and net cash used in the acquisitions of business and technology totaled $32.4 million. Capital expenditures were $3.9 million and $2.0 million in the nine months ended December 31, 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 months ended December 31, 2003, we received $1.0 million in proceeds from the prepayment of a portion of an investment in a private company.

      Net cash used in financing activities was $362,000 for the nine months ended December 31, 2004, and net cash provided by financing activities was $474,000 for the nine months ended December 31, 2003. These cash flows primarily reflect net cash proceeds from exercises of stock options, Employee Stock Purchase Plan common stock issuances and short-term borrowings by the Company’s Japanese subsidiary, offset by payments on capital leases and short-term borrowings in the nine months ended December 31, 2004 and 2003. Net cash proceeds from exercises of stock options and Employee Stock Purchase Plan common stock issuances were $2.9 million and $3.3 million for each of the nine months ended December 31, 2004 and 2003, respectively. Net cash proceeds from short-term borrowings by the Company’s Japanese subsidiary, were $3.5 million and $3.3 million for the nine months ended December 31, 2004 and 2003, respectively. Payments on short-term borrowings were $6.1 million and $3.4 million for the nine months ended December 31, 2004 and 2003, respectively. As of December 31, 2004, the Company had no borrowings outstanding. Payments on capital leases were $747,000 and $2.8 million for the nine months ended December 31, 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 April 30, 2005. We intend to renew the line of credit before it expires. Any borrowings under this line bear interest at the bank’s prime rate per annum. As of December 31, 2004, we had not borrowed against this line of credit. In connection with the line of credit, we have outstanding letters of credit totaling approximately $1.1 million related to office leases. In connection with leasing of replacement office

space, we will be required to supply additional letters of credit that are expected to total $1.5 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.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

      In December 2004 the Financial Accounting Standards Board issued revised SFAS No. 123R, “Share-Based Payment,” which sets forth accounting requirements for “share-based” compensation to employees and requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based compensation. The Company currently provides pro forma disclosure of the effect on net income or loss and earnings or loss per share of the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R is effective in interim or annual periods beginning after June 15, 2005. Accordingly, beginning in its second quarter of fiscal 2006, the Company will be required to adopt SFAS No. 123R and recognize the cost of all share-based payments to employees, including stock option grants, in the income statement based on their fair values. The Company is currently evaluating the impact of the adoption of SFAS 123R on its financial position and results of operations, including the valuation methods and support for the assumptions that underlie the valuation of the awards. However, we currently believe that the adoption of SFAS 123R will have a material effect on our results of operations.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

      You should consider the following factors when evaluating our statements in this report and elsewhere. The Company 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’ 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’ common stock.

      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’ 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, fluctuations in the revenue of our geographic regions, our ability to execute on our business plans, the impact of investigations and changes on management or other personnel in various geographical regions, the amount and timing of operating costs, the costs of investigating allegations or resolving pending or threatened legal claims, delays in the availability of new products or new releases of existing products, costs of legal compliance and modification, testing and remediation of internal controls 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’ 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’ 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 February 11, 2005, the closing price of webMethods’ stock on the Nasdaq National Market has ranged from a high of $308.06 to a low of $3.96.

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’ 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. Growth of revenue from sales of software in Japan may be impacted by the recent investigation of improper activities there.

      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’ 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 webMethods Fabric product suite 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; business integration software vendors; 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 may become or are 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.

Costs of legal investigations and compliance matters, and demands on management time and attention relating to those matters, may increase our operating expenses and impact our operating results.

      The recently-concluded investigation by our Audit Committee concerning certain activities of personnel in our Japanese subsidiary, as well as the costs associated with a personnel matter have resulted in significant expense and management time and attention, and we anticipate that we will incur significant expense relating to the Audit Committee investigation and the associated restatements of financial statements. Further investigations, personnel matters or other legal compliance matters could significantly increase expenses and demands on management time and attention, thereby possibly adversely impacting

our operating results, and potentially leading to unanticipated increases in expenses in the future, which could materially decrease the market price of webMethods’ common stock.

Our financial statements have been impacted, and could again be impacted, by improper activities of our personnel.

      As we have recently experienced with our restatements for the fiscal year ended March 31, 2004 and the three months ended June 30, 2004, our financial statements can be adversely impacted by our employees’ improper activities and unauthorized actions and their concealment of their activities. For instance, revenue recognition depends upon the terms of our agreements with our customers, among other things. Our personnel may act outside of their authority, such as by negotiating additional terms or modifying terms, without our knowledge that could impact our ability to recognize revenue in a timely manner, and they could commit us to obligations or arrangements that may have a serious financial impact to our results of operations or financial condition. In addition, depending upon when we learn of improper activities or unauthorized actions, we may have to restate our financial statements for a previously reported period, which could have a significant adverse impact on our business, operating results and financial condition. We have implemented, and are implementing, new or additional controls to prevent such conduct, but we cannot be certain that these new or additional controls will be effective.

We rely on strategic 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 system integration partners and others. These strategic partners provide us with important sales and marketing opportunities, create opportunities to license our solutions, 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 three quarters of our fiscal year 2005, our 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’ common stock.

      As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted rules requiring public companies to include a report of management on the company’s internal control over financial reporting in their annual reports on Form 10-K. These rules will first apply to webMethods with respect to our fiscal year ending March 31, 2005. To comply with the Sarbanes-Oxley Act and the SEC’s new rules and regulations, we are evaluating our internal control

systems and taking remedial actions to allow management to report on, and our independent auditors to attest to, our internal control over financial reporting. As a result, we have incurred expenses, and expect to incur additional expenses, and diversion of management’s time and attention, which may increase our operating expenses and impair our ability to sustain profitability on a pro forma basis and achieve profitability on a GAAP basis. While we are endeavoring to implement the requirements relating to internal controls and all other aspects of Section 404 in a timely manner, there can be no assurance that we will be able to maintain our schedule to complete all assessment and testing in a timely manner and, if we do not, that we and our independent auditors will have the resources available to complete necessary assessment and reporting on internal controls on a timely basis. The material weakness in our internal controls discovered as a result of the recently-completed internal investigation concerning our Japanese subsidiary increases the difficulty of completing the modification, testing and remediation of our internal controls by March 31, 2005. Further, we cannot be certain that our testing of internal controls and resulting remediation actions will yield adequate internal controls over financial reporting as required by Section 404. If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, there could be an adverse reaction in the financial markets due to a loss of confidence in the reliability of the our financial statements, which could cause the market price of webMethods’ common stock to decline.

      Our management, including our Chief Executive Officer and Chief Financial Officer, do not expect that our disclosure controls and procedures or our internal controls over financial reporting will prevent all errors and fraud. In designing our control systems, management recognizes that any control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives. Further, the design of a control system must reflect the necessity of considering the cost-benefit relationship of possible controls and procedures. Because of inherent limitations in any control system, no evaluation of controls can provide absolute assurance that all control issues and instances of wrongdoing, if any, that may affect our operations have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, that breakdowns can occur because of simple error or mistake and that controls may be circumvented by individual acts by some person, by collusion of two or more people or by management’s override of the control. The design of any control system also is based in part upon certain assumptions about the likelihood of a potential future event, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in cost-effective control systems, misstatements due to error or wrongdoing may occur and not be detected. Over time, it is also possible that controls may become inadequate because of changes in conditions that could not be, or were not, anticipated at inception or review of the control systems.

      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 15 of the Notes to Consolidated Financial Statements of webMethods, Inc. included in our Amendment No. 2 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’ common stock.

      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 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. Our future success will also depend in large part on our ability to attract and retain experienced technical, sales, marketing and management personnel.

      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 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 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; the difficulty of ensuring adherence to our revenue recognition and other policies, internal controls and disclosure controls; 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.

      We expect that the rapid evolution of business integration software 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.

      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.

      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.

      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.

      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.

      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.

      Our Board of Directors adopted a rights plan and declared a dividend distribution of one right for each outstanding share of webMethods’ common 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.

      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 of our subsidiaries located in Australia, Canada, United Kingdom, France, Germany, India, Japan, the Netherlands, the Peoples Republic of China, 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 or other local currency of the country in which our subsidiaries are located, 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.

  Disclosure Controls and Procedures

      Disclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in our reports filed or submitted under the Securities and Exchange Commission’s rules and forms is recorded, processed, summarized and reported within the time periods specified under such rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

      On November 1, 2004, an employee of our Japanese subsidiary notified webMethods’ management of the employee’s concerns regarding certain transactions involving a small number of that subsidiary’s

resellers. The Audit Committee of webMethods’ Board of Directors promptly took action, including hiring independent legal counsel, which in turn engaged forensic accountants, to conduct an independent investigation into the allegations. In late January 2005, the independent legal counsel provided the Audit Committee with a report of its findings. As a result of the investigation, the Company’s Audit Committee concluded that improper activities of certain employees of the Japanese subsidiary caused the Company to misstate revenue and expenses for the year ended March 31, 2004 and certain quarters therein and the three months ended June 30, 2004, as well as misstate accounts receivable, deferred revenue, debt and certain other items attributable to the operations of the Japanese subsidiary. The Company promptly announced that it was restating its financial statements for fiscal year 2004 (ended March 31, 2004), as well as quarterly financial statements for each of the three interim quarterly reports in that fiscal year and for the three months ended June 30, 2004.

      The Audit Committee’s investigation and additional efforts undertaken by the Company found that the improper activities included, among other things, engaging in improper licensing and professional services transactions and misrepresenting the transactions to the Company’s management; causing the Japanese subsidiary to engage in undisclosed and unauthorized borrowings; failing to record expenses and recording improper expenses; and creating false documents in support of improper transactions. The Audit Committee also determined that those employees of the Japanese subsidiary acted to conceal their improper activities from webMethods’ management. As a result of those findings and determinations, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures in effect as of December 31, 2004 were not effective at the reasonable assurance level due to a material weakness in internal controls over financial reporting with respect to our Japanese subsidiary discussed below.

  Internal Controls Over Financial Reporting

      In connection with the Audit Committee investigation and other efforts by the Company, we have identified a material weakness in our internal controls over financial reporting with respect to our Japanese subsidiary in effect as of December 31, 2004. The identified material weakness relates to the ineffectiveness of the procedures relating to our Japanese subsidiary for timely detection, deterrence and mitigation of wrongdoing and improper activities that led to the restatement of our financial statements.

      In order to reduce the risks of recurrence of such material weakness in future periods, we have implemented, or are implementing, the following steps to strengthen our internal controls over financial reporting:

      We are continuing our evaluation, documentation and testing of our internal controls over financial reporting so that management will be able to report on, and our independent registered public accounting firm will be able to attest to, our internal controls as of March 31, 2005, as required by applicable laws and regulations, and we will remediate our internal controls to the extent that our testing reveals inadequacies in the control system. We cannot be certain that our efforts to date will be sufficient to identify and remediate all material weaknesses in our internal controls over financial reporting prior to March 31, 2005. In addition, we have not yet tested the operating effectiveness of all remedial controls, and we cannot be certain that the remedial controls will operate effectively for a sufficient period of time for us to complete our evaluation. We also cannot be certain that sufficient time exists for our independent registered public accounting firm to complete their assessment of the Company’s internal controls over financial reporting by the due date of the Company’s Form 10-K for the fiscal year ended March 31, 2005. We believe we will have adequate internal controls over financial reporting as of March 31, 2005 but we cannot be certain that our independent auditors will be able to attest to our assessment of these controls on a timely basis or that our independent auditors will agree with our assessment of our controls as there is no precedent available by which we can measure the adequacy of our control system in advance.

PART II

OTHER INFORMATION

      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.

      On February 9, 2005, the Board of Directors of webMethods adopted the Second Amended and Restated Bylaws of webMethods, Inc., effective as of such date. The Second Amended and Restated Bylaws of webMethods, attached as Exhibit 3.2 to this Form 10-Q, reflect changes designed to address current developments in securities law and corporate governance, changes in webMethods’ management structure and changes in Delaware corporate law over the past few years. The material changes effected by the Second Amended and Restated Bylaws are to: (i) revise the procedure for stockholders to submit proposals and nominations for directors; (ii) allow for methods of giving notice and holding of stockholder and board meetings using new or improved technologies pursuant to recent amendments to Delaware corporate law; (iii) eliminate the designation of the Chairman of the Board as an officer position reflecting the current status of the non-executive Chairman of the Board; (iv) separate the offices of Chief Executive Officer and President; (v) allow for subcommittees pursuant to recent amendments to Delaware corporate law; and (vi) remove the requirement that the Board of Directors cause an annual audit, which is not required under Delaware corporate law and could be deemed to interfere with the Audit Committee’s duties regarding the audit.

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.

Date: February 14, 2005

Date: February 14, 2005

INDEX TO EXHIBITS