UNITED STATES

(Mark One)

For the transition period from ____________ to ____________.

Commission file number: 0-27207

VITRIA TECHNOLOGY, INC.

945 Stewart Drive
Sunnyvale, California 94086
(408) 212-2700
(Address, including Zip Code, of Registrant’s Principal Executive Offices
and Registrant’s Telephone Number, including Area Code)

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

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

     The number of shares of Vitria’s common stock, $0.001 par value, outstanding as of April 30, 2004 was 32,938,501 shares.

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VITRIA TECHNOLOGY, INC.

Index

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PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

Vitria Technology, Inc.
Condensed Consolidated Balance Sheets
(In thousands)

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

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Vitria Technology, Inc.
Condensed Consolidated Statement of Operations
(In thousands, except per share amounts)
(unaudited)

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

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Vitria Technology, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(unaudited)

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1) Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim consolidated financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. In the opinion of the management of Vitria Technology, Inc., these unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, which we consider necessary to fairly state Vitria’s financial position and the results of its operations and its cash flows. The balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in Vitria’s Annual Report on Form 10-K for the year ended December 31, 2003. The results of Vitria’s operations for any interim period are not necessarily indicative of the results of the operations for any other interim period or for a full fiscal year.

     Stock-based compensation

     Vitria accounts for stock-based employee compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, as amended by FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, issued by the Financial Accounting Standards Board, and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation and SFAS No. 148, Accounting for Stock-based Compensation – Transition and Disclosure. Unearned compensation is amortized and expensed in accordance with Financial Accounting Standards Board Interpretation No. 28 using the multiple option approach.

     Under APB 25 and related interpretations, unearned compensation is based on the difference, on the date of the grant, between the fair value of Vitria’s common stock and the exercise price. Under APB 25, no compensation expense is recognized in Vitria’s financial statements when the exercise price of Vitria’s employee stock options equals the market price of the underlying stock on the date of grant. Vitria has elected to follow APB 25 because the alternative fair value accounting provided for under SFAS 123 requires the use of option valuation models that were not developed for use in valuing employee stock options.

     Pro forma information regarding net loss and net loss per share is required by SFAS 123. This information is required to be determined as if we had accounted for our employee stock options (including shares issued under our Employee Stock Purchase Plan, collectively called “stock based awards”), under the fair value method of that statement.

     The fair value of our stock-based awards to employees in the table below was estimated using the Black-Scholes option-pricing model and the following weighted-average assumptions:

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     The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including the expected volatility of the stock price. Because our stock based awards have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimates, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of our stock based awards.

     The following table illustrates the effect on net loss and loss per share if we had applied the fair value recognition provisions of SFAS 123 to employee stock-based compensation, including shares issued under our stock option plans and Employee Stock Purchase Plan (collectively “options”). For purposes of pro forma disclosures, the estimated fair value of the options is assumed to be amortized to expense over the options’ vesting periods and the amortization of deferred compensation, as calculated under the intrinsic value method, has been added back. Pro forma information follows (in thousands, except per share amounts):

     During the three months ended March 31, 2003, stock-based compensation expense determined under the fair value based method resulted in a positive number in the above table, or a reduction in expense. This is the result of adjustments to reverse previously recognized stock-based compensation expense on employee options forfeited prior to the employee earning the award. Forfeitures refer to awards that do not vest because service or employment requirements are not met. In accordance with SFAS 123, we based our initial estimate of stock-based compensation expense on the total number of options granted. Adjustments are made in the period of forfeiture to reverse previously recognized stock-based compensation expense associated with the unearned portion of a forfeited award.

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     Because the determination of fair value of all options granted prior to the time we became a public entity excludes volatility factors, the above results may not be representative of future periods.

2) Net Loss Per Share

     Basic net loss per share is calculated by dividing net loss by the weighted-average number of shares of common stock outstanding. Basic net loss per share does not include shares subject to Vitria’s right of repurchase, which lapses ratably over the related vesting term. Diluted net loss per share is calculated by dividing net loss by the weighted-average number of shares of common stock outstanding plus shares of potential common stock. Shares of potential common stock are composed of shares of common stock subject to Vitria’s right of repurchase and shares of common stock issuable upon the exercise of stock options (using the treasury stock method). The calculation of diluted net loss per share excludes shares of potential common stock if their effect is anti-dilutive.

     The following table sets forth the computation of basic and diluted net loss per share for the periods indicated (in thousands, except per share amounts). All share amounts in the following table have been restated for all periods presented to reflect the reverse stock split which occurred during the second quarter of 2003 (see Note 7).

     The following table sets forth the weighted average potential shares of common stock that are not included in the diluted net loss per share calculation above because to do so would be anti-dilutive for the periods indicated (in thousands):

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3) Comprehensive Loss

     Comprehensive loss is comprised of net loss and other comprehensive income (loss) such as foreign currency translation gains and losses and unrealized gains or losses on available-for-sale marketable securities. Vitria’s total comprehensive loss was as follows (in thousands):

     The components of accumulated other comprehensive loss are as follows (in thousands):

4) Stock-Based Compensation

     Stock-based compensation is broken down as follows (in thousands):

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5) Restructuring, Impairments and Other Charges

     In the year ended December 31, 2002 we initiated actions to reduce our cost structure due to sustained negative economic conditions that have impacted our operations and resulted in lower than anticipated revenues. In April and August 2002 we reduced our workforce and consolidated our facilities. The restructuring actions in 2002 resulted in a reduction in workforce of approximately 285 employees or 33% of Vitria’s workforce measured as of the beginning of 2002 and affected all departments. Facilities in the United States and United Kingdom were consolidated and related leasehold improvement and equipment were written off. As a result of the restructuring actions, a charge of $19.5 million in the year ended December 31, 2002 was incurred. The restructuring charge included approximately $4.2 million of severance related charges and $15.4 million of committed excess facilities payments, which included $463,000 for the write-off of leasehold improvements and equipment in vacated buildings.

     In the year ended December 31, 2003, we initiated actions to further reduce our cost structure. The restructuring actions in 2003 resulted in a reduction in workforce of approximately 120 employees or 22% of our workforce measured as of the beginning of 2003 and affected all departments. The plan was a combination of a reduction in workforce, consolidations of facilities in the United States and United Kingdom and the associated disposal of leasehold improvements and equipment. The severance related charges consist of one-time termination benefits recognized and measured at fair value at the date the plan was communicated to the employees. The excess facilities payments were measured at fair value as of the cease-use date of the facilities using a discount rate of 6% per annum. The leasehold improvements and equipment write-offs, which were associated with vacating the excess facilities, were based on net book value as of the date of abandonment. As a result of the restructuring actions, a charge of $16.1 million in the year ended December 31, 2003 was incurred. The restructuring charge included approximately $2.9 million of severance related charges and $9.8 million of committed excess facilities payments, $2.2 million in write-offs of leasehold improvements and equipment and $1.0 million for changes in sublease income assumptions for facilities restructured in both 2002 and 2003. In addition we incurred $180,000 in accretion charges in 2003 and $54,000 in accretion charge in the first quarter of 2004 related to the fair value treatment for the facilities we restructured in 2003, in accordance with Statement of Financial Accounting Standard No. 146 (SFAS 146), Accounting for Costs Associated with Exit or Disposal Activities. There were no other restructuring charges or adjustments in the first quarter of 2004. As of March 31, 2004, $16.8 million related to facility closures remains accrued from all of the restructuring actions.

     The facilities consolidation charges for all of our restructuring actions were calculated using our best estimates and were based upon the remaining future lease commitments for vacated facilities from the date of facility consolidation, net of estimated future sublease income. We have engaged brokers to locate tenants to sublease all of the excess facilities and, to date, have signed several sublease agreements. The estimated costs of vacating these leased facilities were based on market information and trend analyses, including information obtained from third-party real estate sources. Our ability to generate estimated sublease income is highly dependent upon the existing economic conditions, particularly lease market conditions in certain geographies, at the time the sublease arrangements are negotiated with third parties. While the amount we have accrued is our best estimate, these estimates are subject to change and may require routine adjustment as conditions change through the implementation period. If macroeconomic conditions related to the commercial real estate market continue to worsen, we may be required to increase our estimated cost to exit certain facilities.

     The total accrued liability for lease termination costs of $16.8 million at March 31, 2004 is net of $5.0 million of estimated sublease income. The portion of this liability related to restructuring actions taken in 2003 is discounted at fair value as required by SFAS 146, which was adopted by us in 2003, and is included in the table below:

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     At March 31, 2004, $6.1 million related to the restructuring activities remained in current liabilities and $10.7 million remained in long-term liabilities. Future lease payments for restructured facilities totaling $16.8 million will be made through 2013.

6) Related Party Transactions

     In December 2003, we sold our interest in our China operations to ChiLin LLC. ChiLin is owned and controlled by Dr. JoMei Chang, a director and a significant stockholder, and Dr. Dale Skeen, a director and our interim Chief Executive Officer and Chief Technology Officer, the spouse of Dr. Chang and a significant stockholder.

     Vitria and ChiLin also entered into a license agreement whereby ChiLin received a royalty-bearing license to distribute Vitria products in China. In addition, Vitria and ChiLin executed a development agreement pursuant to which ChiLin will perform development work and other fee-bearing services for Vitria. During the first quarter of 2004, ChiLin paid Vitria royalty license fees of $100,000 and Vitria paid ChiLin $174,000 for development work performed in the first quarter of 2004.

7) Reverse Stock Split

     On May 19, 2003, our Board of Directors approved a one-for-four reverse split of our common stock. The reverse split was approved by Vitria stockholders on May 16, 2003 and implemented on May 27, 2003. Each four shares of our outstanding common stock automatically converted into one share of common stock.

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All share and per share amounts have been restated for all periods presented to reflect this reverse stock split. In addition, the number of authorized shares of common stock was reduced from 600 million to 150 million shares.

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

     The information in this discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which are subject to the “safe harbor” created by those sections. These forward-looking statements are generally identified by words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “hope,” “assume,” “estimate” and other similar words and expressions. These forward-looking statements involve risks and uncertainties that could cause our actual results to differ materially from those in the forward-looking statements, including, without limitation, the risks outlined under “Business Risks” in this quarterly report on Form 10-Q. These business risks should be considered in evaluating our prospects and future financial performance. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

Overview

     Vitria is a leading provider of business process integration software and services for corporations in healthcare, telecommunications, finance, manufacturing and other markets. Our software automates business processes across multiple existing systems, people and trading partners in order to reduce operating costs, enhance revenues and improve customer service. To accomplish this, we develop and deliver the Vitria:BusinessWare® business process integration software platform together with packaged applications and best practices content. These applications and content are designed to quickly and effectively solve industry-specific business problems such as healthcare claims lifecycle management, straight-through processing in capital markets, and order management for telecommunications and manufacturing.

     Our flagship Vitria:BusinessWare integration platform uses graphically modeled business process logic as the foundation for orchestrating complex interactions between dissimilar software applications, Web services, individuals, and trading partners over corporate networks and the Internet. By automating and measuring previously fragmented business processes from start to finish, our products and services are designed to:

•		Reduce personnel costs, improve customer service, and speed time-to-revenue capture by automating manual processes between systems, people and partners;
•		Enhance visibility into business operations by measuring business performance as it crosses different systems, departments, customers and partners;
•		Enforce industry and company-specific best practices and government regulatory requirements with automated business logic, rules and workflows, and
•		Ensure greater consistency, accuracy and accessibility of corporate-wide data on customers and products.

     We derive revenues primarily from two sources: licenses, and services and other. Our products are typically licensed directly to customers for a perpetual term, with pricing based on the number of copies licensed, or systems or applications managed. Service and other revenues include product maintenance, consulting and training. Customers who license Vitria:BusinessWare normally purchase maintenance contracts. These contracts provide unspecified software upgrades and technical support over a specified term, which is typically twelve months. A majority of our customers use third-party system integrators to implement our products. Customers typically purchase additional consulting services from us to support their implementation activities. We also offer training classes for our customers and system integrators. We market our products through our direct sales force and augment our marketing efforts through relationships with system integrators and technology vendors. Our revenues to date have been derived primarily from accounts in the United States. We have international sales offices in Australia, Brazil, Canada, France, Germany, Italy, Japan, Korea, Mexico, Singapore, Spain and the United Kingdom.

     Over the last three years, the marketplace in which Vitria competes has become increasingly competitive as more companies are offering products in our general markets. Additionally, over the same period increased competition has caused a steady decline in the average purchase price of our products. While we have taken measures in 2002 and 2003 to reduce our overall cost structure to better match lower revenues, we must develop additional products to create revenue growth. Accordingly, we are developing a suite of products targeted to reduce specific components of our customers’ administrative costs. While the success of our efforts cannot be predicted, we feel that our future revenue and margin growth will be dependent upon successfully selling these products.

Industry-Specific Products

  Vitria’s Business Process Integration Software

     While each Vitria customer has unique aspects of their business processes and existing application environment, there are many common business and technical elements to recurring business integration problems that lend themselves to a more standardized, repeatable approach. Pre-building certain applications and components is designed to satisfy customers’ desire for faster time-to-value, lower cost of implementation, and leveraging industry best practices. Pre-built applications and best practices content can include:

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•		business process models;
•		business rules for automated decision-making;
•		human task automation (workflow);
•		operational real-time dashboards and on-demand historical reporting;
•		exception handling rules and workflows;
•		data translations and validation rules;
•		application connectors; and
•		third-party applications and components.

     Because these components are built on our general-purpose Vitria:BusinessWare integration platform, each is configurable to meet customers’ unique business and technology requirements.

     Vitria combines technology leadership with industry domain expertise in healthcare, telecommunications, finance and manufacturing to automate and streamline strategic business processes across systems, people and trading partners. Using pre-built applications, content, platform and in conjunction with services to deliver business process integration solutions that preserve and extend a company’s existing technology investments, Vitria’s applications are designed to provide real-time visibility and streamlined control over processes and data to reduce costs, increase revenues, improve customer experience, and ensure regulatory compliance.

     Vitria has developed years of intellectual property around automating industry-specific business processes in our target markets that can be either pre-packaged in software applications that run on the Vitria:BusinessWare platform, or used by Vitria’s client services teams to more rapidly implement and configure applications. This focus on business processes allows Vitria to concentrate our product development and marketing efforts on demonstrating the measurable business value of process integration to business executives, in addition to demonstrating the technical value of our platform to information technology professionals. Examples of Vitria’s packaged applications include:

•		Vitria:SmartClaims: a packaged application designed to improve a healthcare payer’s automation of claims processing. Vitria:SmartClaims augments a payer’s legacy claims processing systems with automated business rules, processes and human workflows to prevent, automatically resolve, and expedite the resolution of issues that prevent full automation of each claims payment decision. Vitria:SmartClaims improves business agility by empowering business users to quickly and directly automate new policies with intuitive business rules.
•		Vitria:OrderAccelerator: a packaged software application that automates business processes across a telecommunications service provider’s existing systems for more cost-efficient and accurate order management. Vitria:OrderAccelerator includes pre-built business processes and content based on the Telemanagement Forum’s eTOM (Enhanced Telecom Operations Map) as well as best practices Vitria has incorporated from successful implementations with its telecom customers.
•		Vitria:SmartResponse: a packaged application designed to reduce healthcare insurers’ medical management administrative costs by automating the processes and decision logic by which physicians and hospitals submit requests for medical service authorizations and referrals, and by which insurers receive, decide and respond to those requests.
•		CleanOrder: a package of pre-built content for manufacturing companies to quickly achieve consolidated order management. CleanOrder intelligently manages customer orders across multiple existing systems,

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		trading partners and internal organizations, resulting in a single-point order and fulfillment management system without the risk and cost of big-budget Enterprise Resource Planning (ERP) implementations.
•		Accenture Straight Through Processing (STP) Integration Platform, powered by Vitria: a package of pre-built content co-designed and co-marketed with Accenture to enable efficient, end-to-end transaction processing automation for broker/dealers, asset managers and custodians in order to reduce exception processing costs, reduce trade correction costs, and manage operational risks in real time.
•		SWIFT Management: a package of pre-built content to allow banks and brokerages to automatically generate messages that are compliant with the ever-changing requirements of the SWIFT financial network, convert between formats and repair failed trades in order to cut operational costs and optimize operations.

  Vitria’s BusinessWare Platform

     Vitria:BusinessWare unifies the five elements that we believe are essential for business process integration software, all in a single platform:

(1)		Business Process Management, or BPM: BPM manages the steps of a cross-functional business process to ensure optimal completion of the process (e.g., from submission of a healthcare claim by a care provider to the remittance of payment by an insurer). It uses graphical business process models together with automated human workflows to define, automate and orchestrate transactions and the exchange of information between internal business applications, people and external trading partners.
(2)		Business Analysis and Monitoring, or BAM: BAM provides both historic and real-time monitoring and analysis of business processes, providing greater visibility and business intelligence needed to optimize operational efficiency. Our two key BAM components, Cockpit and Analyzer, are designed to continuously gather business process data across applications, human workflows and trading partner interactions; analyze and visualize this data in real time; and enable business executives and process owners to identify and respond to both business and integration problems or opportunities as they occur.
(3)		Business Vocabulary Management, or BVM: BVM is comprised of content and tools that enable the flexible, scalable management of translations between industry-specific and application-specific data formats and meanings (vocabularies) as represented in electronic transactions between businesses (e.g. via Electronic Data Interchange, or EDI, or eXtensible Markup Language, or XML), and between a company’s internal applications. BVM uses automated exception handling, business rules-based validation and advanced data transformation designed to ensure that differences in how data is represented does not interfere with successful completion of a business transaction (e.g. fulfilling a customer’s order, processing a healthcare claim, or settling a financial transaction). To address the specific needs of each industry, BVM provides packaged vocabularies for various industries based on the specific business terms used within those industries.
(4)		Business-to-Business Integration, or B2B: B2B enables the secure and reliable completion of transactions and the exchange of business information between customers and partners over the Internet to support collaborative business processes. Combined with BPM and BAM, B2B helps companies manage their value chain interactions from end to end as an integrated part of their larger business processes.
(5)		Enterprise Application Integration, or EAI: EAI enables the secure and reliable movement of

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information in and out of internal business applications. By enabling internal applications to communicate with one another, EAI helps unify and improve enterprise processes while maximizing the value of a company’s application investments. Companies may use Vitria:BusinessWare’s BPM, BAM and BVM capabilities to control business processes on top of industry-standard methods of transporting data from application to application (such as Web services and Java Messaging Service) or third-party EAI infrastructures.

     Vitria:BusinessWare allows customers to solve their business problems using graphical models rather than developing custom programs. Instead of writing new software programs, business managers can create visual diagrams of business processes, called “process models,” using a point-and-click user interface. Vitria:BusinessWare then translates these process models into software programs that automate the flow of information across a company’s underlying IT systems.

     Once customers use Vitria:BusinessWare to define their business process models and integrate the underlying IT systems, people and partners, Vitria:BusinessWare automatically controls the flow of information across the IT systems as specified by the process models. Vitria:BusinessWare continuously analyzes the customer’s business processes and can automatically change the processes in response to this analysis. This capability allows companies to transform the information flowing through their IT systems into “actionable intelligence” that enables business managers to optimize their business operations.

CRITICAL ACCOUNTING POLICIES

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

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

  Revenue Recognition

     We derive revenues from software licenses to end users for Vitria:BusinessWare and other products and related services, which include maintenance and support, consulting and training services. In accordance with the provisions of Statement of Position 97-2, Software Revenue Recognition, as amended, we record revenue from software licenses when a license agreement is signed by both parties, the fee is fixed or determinable, collection of the fee is probable and delivery of the product has occurred. For electronic delivery, the product is considered to have been delivered when the access code to download the software from the Internet has been provided to the customer. If an element of the agreement has not been delivered, revenue for the element is deferred based on vendor-specific objective evidence of fair value. If vendor-specific objective evidence of fair value does not exist for the undelivered element, all revenue is deferred until sufficient objective evidence exists or all elements have been delivered. We treat all arrangements with payment terms longer than normal not to be fixed or determinable. Our normal payment terms currently range from “net 30 days” to “net 90 days” for domestic and international customers, respectively. Revenue is generally deferred for those agreements which exceed our normal payment terms and are therefore

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assessed as not being fixed or determinable. Revenue under these agreements is recognized as payments become due unless collectibility concerns exist, in which case revenue is deferred until payments are received. Our assessment of collectibility is particularly critical in determining whether revenue should be recognized in the current market environment. If collectibility is not considered probable, revenue is recognized when the fee is collected. Revenue on arrangements with customers who are not the ultimate users, primarily third-party systems integrators, is not recognized until evidence of a sell-through arrangement to an end user has been received.

     Service and other revenues include product maintenance, consulting, and training. Customers who license Vitria:BusinessWare normally purchase maintenance contracts. These contracts provide unspecified software upgrades and technical support over a specified term, which is typically twelve months. Maintenance contracts are usually paid in advance, and revenues from these contracts are recognized ratably over the term of the contract. A majority of our customers use third-party system integrators to implement our products. Customers typically purchase additional consulting services from us to support their implementation activities. These consulting services are generally sold on a time and materials basis and recognized as the services are performed. We also offer training services which are sold on a per student or per class basis and recognized as the classes are attended.

     Payments received in advance of revenue recognition are recorded as deferred revenue. When the software license arrangement requires us to provide consulting services for significant production, customization or modification of the software, or when the customer considers these services essential to the functionality of the software product, both the product license revenue and consulting services revenue are recognized in accordance with the provision of Statement of Position 81-1, Accounting for Performance of Construction Type and Certain Production Type Contracts. We recognize revenue from these arrangements using the percentage of completion method based on cost inputs and, therefore, both product license and consulting services revenue are recognized as work progresses. These arrangements have not been common and, therefore, the significant majority of our license revenue in the past three years has been recognized under SOP 97-2, as amended.

  Allowance for Doubtful Accounts

     We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to deliver required payments to us. When we believe a collectibility issue exists with respect to a specific receivable, we record an allowance to reduce that receivable to the amount that we believe is collectible. In addition, we record an allowance on the remainder of our receivables that are still in good standing based on our past write off experience. If the financial condition of our customers were to deteriorate in the future, resulting in an impairment of their ability to make payments, additional allowances may be required.

  Restructuring Charges

     We recorded $19.5 million in restructuring charges related to the realignment of our business operations in 2002. During 2003, we recorded an additional $16.1 million of restructuring charges related to the realignment of our business operations. In the first quarter of 2004 we did not incur any restructuring charges except for accretion charges related to the fair value treatment for the facilities we restructured in 2003, in accordance with SFAS 146. As of March 31, 2004, we have $16.8 million in accrued restructuring expenses, consisting entirely of future lease payments which will be paid out through 2013.

     Only costs resulting from a restructuring plan that are not associated with, or that do not benefit activities that will be continued, are eligible for recognition as liabilities at the commitment date. These charges represent expenses incurred in connection with certain cost reduction programs that we have undertaken, and consist primarily of the cost of involuntary termination benefits and remaining contractual lease payments and other costs associated with closed facilities net of anticipated sublease income. Information regarding sublease income estimates for the amount of

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sublease income we are likely to receive and the timing of finding a tenant has been obtained from third party experts and are based on prevailing market rates.

     The charges for facility closure costs require the extensive use of estimates, including estimates and assumptions related to future maintenance costs, our ability to secure sub-tenants and anticipated sublease income to be received in the future. If we fail to make accurate estimates or to complete planned activities in a timely manner, we might record additional charges or reverse previous charges in the future. Such additional charges or reversals will be recorded to the restructuring charges line in our statement of operations in the period in which additional information becomes available to indicate our estimates should be adjusted. Since April 2002, we have revised our sublease income estimates at least semi-annually due to significant downward trends in the real estate markets in the United States and in the United Kingdom.

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RESULTS OF OPERATIONS
For the three months ended March 31, 2004 and 2003

     The following table sets forth the results of operations for the three months ended March 31, 2004 and 2003, expressed as a percentage of total revenues.

Revenues

     In the three months ended March 31, 2004, our revenues from customers outside the United States increased to 43% compared to 26% in the three months ended March 31, 2003 as our U.S. license revenues decreased significantly from the prior period. To date, we have not experienced significant seasonality of revenue. We expect that future results may be affected by the fiscal or quarterly budget cycles of our customers.

     Sales to our ten largest customers accounted for 35% of total revenues in the three months ended March 31, 2004 and 51% of total revenues in the three months ended March 31, 2003. No single customer accounted for more

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than 10% of total revenues in the three months ended March 31, 2004. Two customers accounted for 19% and 13% of our total revenues in the three months ended March 31, 2003. We expect that revenues from a limited number of customers will continue to account for a large percentage of total revenues in future quarters. Therefore, the loss or delay of individual orders could have a significant impact on revenues. Our ability to attract new customers will depend on a variety of factors, including the reliability, security, scalability and the overall cost-effectiveness of our products.

     License. License revenues decreased 68% from $10.5 million in the three months ended March 31, 2003 to $3.4 million in the three months ended March 31, 2004. This decrease was due to fewer total orders and a decrease in our average deal size. The decrease in our average deal size was due to downward pricing pressure on our base Vitria:Businessware software offering. The maturation of the market in which we compete has resulted in fewer total orders as competition has increased for a smaller pool of potential buyers. The general slowdown in information technology spending in our target markets due to slow U.S. economic growth has made it more difficult for us to grow our revenues.

     Service and other. The level of service revenue is impacted by the number and size of license deals in a given period. Support for the first year is purchased as part of each license deal. Most of our consulting project revenue and customer training revenue is also affected by the size and number of license deals. Service and other revenue also includes support renewals, which is dependent upon our installed license base. Service and other revenues decreased 10% from $12.1 million in the three months ended March 31, 2003 to $10.9 million in the three months ended March 31, 2004. Consulting revenue decreased significantly primarily due to a delay in obtaining final sign off on consulting services of approximately $900,000 in the three months ended March 31, 2004. We had already received payment for these services at March 31, 2004. However, the signoff was not received until April 2, 2004 therefore the revenue will be recognized in the second quarter of fiscal 2004. First year support decreased slightly, related to our decrease in license revenue. Both of these declines were partially offset by an increase in support renewals from customers who had purchased our products in previous years.

Cost of Revenues

     License. Cost of license revenues consists of royalty payments to third parties for technology incorporated into our products. Fluctuations in cost of license is generally due to the buying patterns of our customers, as cost of license revenues is dependent upon which products our customers purchase, and which of those purchased products have third-party technology incorporated into them. Cost of license revenues increased 110% from $94,000 in the three months ended March 31, 2003 to $198,000 in the three months ended March 31, 2004. This fluctuation as well as future fluctuations in cost of license revenues are due to increases or decreases in sales of those particular products which incorporate third-party technology.

     Service and other. Cost of service and other revenues consists of salaries, facility costs, travel expenses and third party consultant fees incurred in providing customer support, training and implementation related services. Cost of service and other revenues decreased 13% from $7.0 million in the three months ended March 31, 2003 to $6.1 million in the three months ended March 31, 2004. This decrease is primarily due to a decrease of $117,000 in salary and benefit expenses arising from our workforce reductions in 2003 and associated decreases of approximately $359,000 in facility costs related to the headcount reductions, as well as reduced travel expenses of $240,000 due to fewer consulting projects in the first quarter of 2004. For the next quarter, we expect that cost of service and other will decrease slightly as a result of further efforts to control costs.

Operating Expenses

     Sales and marketing. Sales and marketing expenses consist of salaries, commissions, field office expenses, travel and entertainment, and promotional expenses. Sales and marketing expenses decreased 50% from $13.0 million in the three months ended March 31, 2003 to $6.6 million in the three months ended March 31, 2004. This decrease was primarily due to decreases in salary and benefit expenses of $2.8 million and reduced travel expenses of $613,000 due to our workforce reduction in the first quarter of 2003, lower external consulting expenses of $777,000

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due to cost containment efforts, lower commission expenses of $694,000 due to lower revenues in the three months ended March 31, 2004, as well as related decreases in most other expense areas as a result of our cost containment efforts. For the next quarter, we expect that sales and marketing expenses will remain flat compared to the quarter ended March 31, 2004.

     Research and development. Research and development expenses include costs associated with the development of new products, enhancements to existing products, and quality assurance activities. These costs consist primarily of employee salaries, benefits, and the cost of consulting resources that supplement the internal development team. Research and development expenses decreased 12% from $5.3 million in the three months ended March 31, 2003 to $4.7 million in the three months ended March 31, 2004. This decrease was primarily due to a decrease of $200,000 in salary expenses arising from our workforce reduction in the first quarter of 2003 and reduced facilities costs of $298,000 due to our facilities restructuring in the first quarter of 2003 as well as related decreases in most other expense areas as a result of our cost containment efforts. For the next quarter, we expect that research and development expenses will remain flat compared to the quarter ended March 31, 2004.

     General and administrative. General and administrative expenses consist of salaries for administrative, executive and finance personnel, information systems costs, outside professional service fees and our provision for doubtful accounts. General and administrative expenses decreased 16% from $3.9 million in the three months ended March 31, 2003 to $3.3 million in the three months ended March 31, 2004. This decrease was primarily attributable to a decrease of $189,000 in salaries and benefit expenses as a result of our workforce reduction in the first quarter of 2003 and related decreases in most other expense areas as a result of our cost containment efforts. For the next quarter, we expect that general and administrative expenses will increase slightly compared to the quarter ended March 31, 2004 due to increasing costs of complying with the Sarbanes-Oxley Act.

     Stock-based compensation. Total stock-based compensation expenses were $41,000 for the three months ended March 31, 2004 and $153,000 for the three months ended March 31, 2003. Stock-based compensation includes the amortization of unearned employee stock-based compensation on options issued to employees prior to Vitria completing its initial public offering in September 1999 and is being amortized over a five-year vesting period. We expect to recognize employee stock-based compensation expenses of approximately $38,000 for the remaining nine months of 2004. This unearned compensation expense will be reduced in future periods to the extent that options are terminated prior to vesting.

     Restructuring charges. In the year ended December 31, 2002 Vitria initiated actions to reduce our cost structure due to sustained negative economic conditions that have impacted our operations and resulted in lower than anticipated revenues. In April and August 2002 we reduced our workforce and consolidated our facilities. The restructuring actions in 2002 resulted in a reduction in workforce of approximately 285 employees or 33% of Vitria’s workforce measured as of the beginning of 2002 and affected all departments. Facilities in the United States and United Kingdom were consolidated and related leasehold improvement and equipment were written off. As a result of the restructuring actions, a charge of $19.5 million in the year ended December 31, 2002 was incurred. The restructuring charge included approximately $4.2 million of severance related charges and $15.4 million of committed excess facilities payments, which included $463,000 for the write-off of leasehold improvements and equipment in vacated buildings.

     In the year ended December 31, 2003, we initiated actions to further reduce our cost structure. The restructuring actions in 2003 resulted in a reduction in workforce of approximately 120 employees or 22% of our workforce measured as of the beginning of 2003 and affected all departments. The plan was a combination of a reduction in workforce, consolidations of facilities in the United States and United Kingdom and the associated disposal of leasehold improvements and equipment. The severance related charges consist of one-time termination benefits recognized and measured at fair value at the date the plan was communicated to the employees. The excess facilities payments were measured at fair value as of the cease-use date of the facilities using a discount rate of 6% per

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annum. The leasehold improvements and equipment write-offs, which were associated with vacating the excess facilities, were based on net book value as of the date of abandonment. As a result of the restructuring actions, a charge of $16.1 million in the year ended December 31, 2003 was incurred. The restructuring charge included approximately $2.9 million of severance related charges and $9.8 million of committed excess facilities payments, $2.2 million in write-offs of leasehold improvements and equipment and $1.0 million for changes in sublease income assumptions for facilities restructured in both 2002 and 2003. In addition we incurred $180,000 in accretion charges in 2003 and $54,000 in accretion charge in the first quarter of 2004 related to the fair value treatment for the facilities we restructured in 2003, in accordance with Statement of Financial Accounting Standard No. 146 (SFAS 146), Accounting for Costs Associated with Exit or Disposal Activities. There were no other restructuring charges or adjustments in the first quarter of 2004. As of March 31, 2004, $16.8 million related to facility closures remains accrued from all of the restructuring actions.

     The total accrued liability for lease termination costs of $16.8 million at March 31, 2004 is net of $5.0 million of estimated sublease income. A portion of this liability is based on the fair value treatment required by SFAS 146, which we adopted as of January 31, 2003.

     The facilities consolidation charges for all of our restructuring actions were calculated using our best estimates and were based upon the remaining future lease commitments for vacated facilities from the date of facility consolidation, net of estimated future sublease income. We have engaged brokers to locate tenants to sublease all of the excess facilities and, to date, have signed several sublease agreements. The estimated costs of vacating these leased facilities were based on market information and trend analyses, including information obtained from third-party real estate sources. Our ability to generate estimated sublease income is highly dependent upon the existing economic conditions, particularly lease market conditions in certain geographies, at the time the sublease arrangements are negotiated with third parties. While the amount we have accrued is our best estimate, these estimates are subject to change and may require routine adjustment as conditions change through the implementation period. If macroeconomic conditions related to the commercial real estate market continue to worsen, we may be required to increase our estimated cost to exit certain facilities.

     Interest income and other income (expense), net. Interest and other income (expense), net, decreased 46%, from $205,000 in the three months ended March 31, 2003 to $111,000 in the three months ended March 31, 2004. The decrease is primarily attributable to lower interest income due to lower cash and investment balances, offset by an increase in foreign currency exchange gain.

Provision for income taxes

     We recorded an income tax provision of $120,000 and $65,000 for the three-month periods ended March 31, 2004 and 2003, respectively. Income tax provisions in both periods presented relate to income taxes currently payable on income generated in non-U.S. tax jurisdictions, state income taxes, and foreign withholding taxes incurred on software license revenue.

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Liquidity and Capital Resources

     As of March 31, 2004, we had approximately $91.0 million in cash, cash equivalents and short term investments, $31.6 million in short term liabilities and $10.8 million in long term liabilities.

     Net cash used in operating activities decreased $14.5 million, or 95%, in the three months ended March 31, 2004 compared to the three months ended March 31, 2003. This decrease was primarily due to a decrease in our net loss as we reduced our expenses over the prior year, a decrease in our accounts receivable balances as we collected more cash than the prior year, offset by a decrease in accrued restructuring balance as we paid down our restructuring liabilities.

     Net cash provided by investing activities decreased $561,000, or 47%, in the three months ended March 31, 2004 compared to the three months ended March 31, 2003. This decrease in the current period was primarily due to the fact that the net maturities of our investments (maturities minus purchases) were less in the first quarter of 2004 than in the first quarter of 2003.

     Net cash provided by (used in) financing activities increased $258,000, in the three months ended March 31, 2004 as compared to the three months ended March 31, 2003. Net cash provided by (used in) financing activities in both the current and prior periods was primarily from the issuance of common stock.

     During the three months ended March 31, 2004, our net accounts receivable balance decreased $4.6 million from $15.5 million at December 31, 2003 to $10.9 million at March 31, 2004. The reason for the decrease was that cash was collected on most of the invoices that were due. An additional contributing factor for the decline in the receivable balance was the decrease in revenues during the first quarter as compared to the prior quarter. At March 31, 2004, our gross accounts receivable balance is $11.3 million with an allowance for doubtful accounts of $421,000 which is essentially unchanged from the allowance balance at December 31, 2003.

     During the three months ended March 31, 2004, our deferred revenue balance increased $2.4 million from $13.9 million at December 31, 2003 to $16.3 million at March 31, 2004. The primary reason for this increase in deferred revenue is an increase in support renewals.

  Contractual Cash Obligations and Commitments

     At March 31, 2004, we had contractual obligations and commercial commitments of approximately $24.1 million as shown in the table below. The table below excludes obligations related to accounts payable and accrued liabilities incurred in the ordinary course of business.

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     Operating lease commitments shown above, which are net of contractual sublease agreements, include $19.6 million of operating lease commitments under leases for vacated facilities which were recorded as accrued restructuring expenses in the accompanying balance sheet as of March 31, 2004. This $19.6 million lease commitment is net of $2.3 million in contractual sublease income. We do not have any material commercial commitments under lines of credit, standby lines of credit, standby repurchase obligations or other such arrangements, except as disclosed below in the section entitled “Credit Facilities with Silicon Valley Bank.”

  Off-Balance Sheet Arrangements

     At March 31, 2004, Vitria did not have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

  Credit Facilities with Silicon Valley Bank

     We have a $15.0 million revolving line of credit agreement with Silicon Valley Bank. Interest on outstanding borrowings accrues at the bank’s prime rate of interest. The facility is secured by all of Vitria’s assets. The agreement includes restrictive covenants which require us to maintain, among other things, minimum cash, cash equivalents, and short-term investments balance of $80.0 million. As part of this $80.0 million balance, the agreement also requires us to maintain a minimum balance of $25.0 million in investments which are invested through Silicon Valley Bank. The line of credit serves as collateral for letters of credit and other commitments, even though these items do not constitute draws on the line of credit. Available advances under the line of credit are reduced by the amount of outstanding letters of credit and other commitments.

     As of March 31, 2004, we had not borrowed against this line of credit. In connection with the line of credit agreement, we have outstanding letters of credit of approximately $8.8 million related to certain office leases at March 31, 2004.

  Operating Capital and Capital Expenditure Requirements

     Estimated future uses of cash over the next twelve months are primarily to fund operations and to a lesser extent to fund capital expenditures. For the next twelve months, we expect to fund these uses from available cash balances, cash generated from operations, if any, and interest on available cash and investment balances. Our ability to generate cash from operations is dependent upon our ability to sell our products and services and generate revenue,

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as well as our ability to manage our operating costs. In turn, our ability to sell our products is dependent upon both the economic climate and the competitive factors of the marketplace in which we operate.

     In the past, we have invested significantly in our operations. We intend to continue to invest selectively in sales, marketing, and research and development. In addition, for the next year, we anticipate that operating expenses and planned capital expenditures will continue to constitute a material use of our cash resources. We expect our capital expenditures in the current year to be approximately $1.0 million. In addition, we may utilize cash resources to fund acquisitions or investments in other businesses, technologies or products lines. We believe that our available cash, cash equivalents and short-term investments will be sufficient to meet our working capital and operating expense requirements for at least the next twelve months. At some point in the future we may require additional funds to support our working capital and operating expense requirements or for other purposes and may seek to raise these additional funds through public or private debt or equity financings. If we need to seek additional financing, there is no assurance that this additional financing will be available, or if available, will be on reasonable terms and not dilutive to our stockholders.

     We believe our success requires expanding our customer base and continuing to enhance our Vitria:BusinessWare products. Our revenues, operating results and cash flows depend upon the volume and timing of customer orders and payments and the date of product delivery. Historically, a substantial portion of revenues in a given quarter have been recorded in the third month of that quarter, with a concentration of these revenues in the last two weeks of the third month. We expect this trend to continue and, therefore, any failure or delay in the closing of orders would have a material adverse effect on our quarterly operating results and cash flows. Since our operating expenses are based on anticipated revenues and because a high percentage of these expenses are relatively fixed, a delay in the recognition of revenue from one or more license transactions could cause significant variations in operating results from quarter to quarter and cause unexpected results. Revenues from contracts that do not meet our revenue recognition policy requirements for which we have been paid or have a valid receivable are recorded as deferred revenues. While a portion of our revenues each quarter is recognized from deferred revenue, our quarterly performance will depend primarily upon entering into new contracts to generate revenues for that quarter. New contracts may not result in revenue during the quarter in which the contract was signed, and we may not be able to predict accurately when revenues from these contracts will be recognized. Our future operating results and cash flows will depend on many factors, including the following:

•		size and timing of customer orders and product and service delivery;
•		level of demand for our professional services;
•		changes in the mix of our products and services;
•		ability to protect our intellectual property;
•		actions taken by our competitors, including new product introductions and pricing changes;
•		costs of maintaining our operations;
•		introduction of new products;
•		timing of our development and release of new and enhanced products;
•		costs and timing of hiring qualified personnel;
•		success in maintaining and enhancing existing relationships and developing new relationships with system integrators;

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•		technological changes in our markets, including changes in standards for computer and networking software and hardware;
•		deferrals of customer orders in anticipation of product enhancements or new products;
•		delays in our ability to recognize revenue as a result of the decision by our customers to postpone software delivery, or because of changes in the timing of when delivery of products or services is completed;
•		customer budget cycles and changes in these budget cycles;
•		external economic conditions;
•		availability of customer funds for software purchases given external economic factors;
•		costs related to acquisition of technologies or businesses;
•		ability to successfully integrate acquisitions;
•		changes in strategy and capability of our competitors; and
•		liquidity and timeliness of payments from international customers.

     As a result of these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. It is likely that in some future quarter our operating results will be below the expectations of public market analysts and investors. In this event, the price of our common stock would likely decline.

Related Party Transactions

     In December 2003, Vitria sold its interest in its China operations to ChiLin LLC. ChiLin is owned and controlled by Dr. JoMei Chang, a director and a significant stockholder, and Dr. Dale Skeen, a director and our interim Chief Executive Officer and Chief Technology Officer, the spouse of Dr. Chang and a significant stockholder.

     Vitria and ChiLin also entered into a license agreement whereby ChiLin received a royalty-bearing license to distribute Vitria products in China. In addition, Vitria and ChiLin executed a development agreement pursuant to which ChiLin will perform development work and other fee-bearing services for Vitria. During the first quarter of 2004, ChiLin paid Vitria royalty license fees of $100,000 and Vitria paid ChiLin $174,000 for development work performed in the first quarter of 2004.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

     The following discussion about our risk management activities includes “forward-looking statements” that involve risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements for the reasons described under the caption “Risks Associated with Vitria’s Business and Future Operating Results.”

Interest Rate Risk

     Our exposure to market risk for changes in interest rates relates to our investment portfolio, which consists of short-term money market instruments and debt securities with maturities between 90 days and one year. We do not use derivative financial instruments in our investment portfolio. We place our investments with high credit quality issuers and, by policy, we limit the amount of credit exposure to any one issuer.

     We mitigate default risk by investing in high credit quality securities and by monitoring the credit rating of investment issuers. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity. These securities are generally classified as available for sale, and consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported, as a separate component of stockholders’ equity, net of tax. Unrealized gains and losses at March 31, 2004 were not material.

     We have no cash flow exposure due to rate changes for cash equivalents and cash investments as all of these investments are at fixed interest rates.

     There has been no material change in our interest rate exposure since March 31, 2004.

     Table of investment securities (in thousands) as of March 31:

Foreign Exchange Risk

     As a global concern, we face exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial position and results of operations. Historically, our primary exposures have related to non-U.S. dollar-denominated currencies, customer receivables, and inter-company receivables or payables with our foreign subsidiaries. Additionally, we provide funding to our foreign subsidiaries in Europe, Asia Pacific and Latin America.

     In order to reduce the effect of foreign currency fluctuations, from time to time, we utilize foreign currency forward exchange contracts (forward contracts) to hedge certain foreign currency transaction exposures outstanding during the period. The gains and losses on the forward contracts help to mitigate the gains and losses on our outstanding foreign currency transactions. We do not enter into forward contracts for trading purposes. All foreign

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currency transactions and all outstanding forward contracts are marked-to-market at the end of the period with unrealized gains and losses included in other income, net.

     We had no outstanding forward contracts as of March 31, 2004.

RISKS ASSOCIATED WITH VITRIA’S BUSINESS AND FUTURE OPERATING RESULTS

Our operating results fluctuate significantly and an unanticipated decline in revenue may disappoint securities analysts or investors and result in a decline in our stock price.

     Our quarterly operating results have fluctuated significantly in the past and may vary significantly in the future. If our operating results are below the expectations of securities analysts or investors, our stock price is likely to decline. Period-to-period comparisons of our historical results of operations are not necessarily a good predictor of our future performance.

     Our revenues and operating results depend upon the volume and timing of customer orders and payments and the date of product delivery. Historically, a substantial portion of revenues in a given quarter have been recorded in the third month of that quarter, with a concentration of these revenues in the last two weeks of the third month. We expect this trend to continue and, therefore, any failure or delay in the closing of orders would have a material adverse effect on our quarterly operating results. Since our operating expenses are based on anticipated revenues and because a high percentage of these expenses are relatively fixed, a delay in the recognition of revenue from one or more license transactions could cause significant variations in operating results from quarter to quarter and cause unexpected results.

     Our quarterly results depend primarily upon entering into new or follow-on contracts to generate revenues for that quarter. New contracts may not result in revenue in the quarter in which the contract was signed, and we may not be able to predict accurately when revenues from these contracts will be recognized. Our operating results are also dependent upon our ability to manage our cost structure.

We have incurred substantial operating losses since inception and we cannot guarantee that we will become profitable in the future.

     We have incurred substantial losses since inception as we funded the development of our products and the growth of our organization. We have an accumulated deficit of $208.4 million as of March 31, 2004. Since the beginning of 2002, we have reduced our workforce by a total of 405 employees and consolidated certain facilities as part of our restructuring plan. As a result of these actions, we incurred a restructuring charge of $19.5 million in 2002 and $16.1 million in 2003. Despite these recent measures in order to remain competitive we intend to continue investing selectively in sales, marketing and research and development. As a result, we may report future operating losses and cannot guarantee whether we will report net income in the future.

Our operating results are substantially dependent on license revenues from essentially one product, Vitria:BusinessWare product and our business could be materially harmed by factors that adversely affect the pricing and demand for Vitria:BusinessWare.

     Since 1998, a majority of our total revenues has been, and is expected to be, derived from the license of our Vitria:BusinessWare product and for applications built using that product. Accordingly, our future operating results will depend on the demand for Vitria:BusinessWare by existing and future customers, including new and enhanced releases that are subsequently introduced. If our competitors release new products that are superior to Vitria:BusinessWare in performance or price, or we fail to enhance Vitria:BusinessWare and introduce new products in a timely manner, demand for our product may decline. A decline in demand for Vitria:BusinessWare as a result of

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competition, technological change or other factors would significantly reduce our revenues. We experienced a decrease in our average deal size in 2003 and in the first quarter of 2004 due to downward pricing pressure on our base Vitria:Businessware software offering. The maturation of the market in which we compete has resulted in fewer total orders as competition has increased for a smaller pool of potential buyers. The general slowdown in information technology spending in our target markets due to slow U.S. economic growth has also made it more difficult to grow our revenues.

Failure to raise additional capital or generate the significant capital necessary to expand our operations and invest in new products could reduce our ability to compete and result in lower revenues.

     During the three months ended March 31, 2004, we had a net loss of $6.6 million and our operating activities used $766,000 of cash. As of March 31, 2004, we had approximately $91.0 million in cash and cash equivalents and short-term investments, $31.6 million in short-term liabilities, and $10.8 million in long-term liabilities. We may need to raise additional funds, and we cannot be certain that we will be able to obtain additional financing on favorable terms, or at all. If we need additional capital and cannot raise it on acceptable terms, we may not be able to, among other things:

•		develop or enhance our products and services;
•		acquire technologies, products or businesses;
•		expand operations, in the United States or internationally;
•		hire, train and retain employees; or
•		respond to competitive pressures or unanticipated capital requirements.

     Our failure to do any of these things could result in lower revenues and could seriously harm our business.

The challenging economic environment in the United States and abroad, and especially the continued reluctance of companies to make significant expenditures on information technology, could reduce demand for our products and cause our revenues to continue to decline.

     The downturn in the U.S. and the world economy may cause a further decline in capital allocations for software purchases. The delay in capital expenditures may cause a decrease in sales, may cause an increase in our accounts receivable and may make collection of license and support payments from our customers more difficult. Over approximately the past two years, we have experienced a general slow-down in the level of capital spending by some of our customers due to the general economic downturn, which has resulted in lower revenues. This slow-down in capital spending, if sustained in future periods, could result in reduced sales or the postponement of sales to our customers. There can be no assurance that the level of spending on information technology in general, or on business integration software by our customers and potential customers, will increase or remain at current levels in future periods. Lower spending on information technology could result in reduced license sales to our customers, reduced overall revenues, diminished margin levels, and could impair our operating results in future periods.

We experience long and variable sales cycles, which could have a negative impact on our results of operations for any given quarter.

     Our products are often used by our customers to deploy mission-critical solutions used throughout their organization. Customers generally consider a wide range of issues before committing to purchase our products, including product benefits, ability to operate with existing and future computer systems, ability to accommodate increased transaction volume and product reliability. Many customers will be addressing these issues for the first time.

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As a result, we or other parties, including system integrators, must educate potential customers on the use and benefits of our product and services. In addition, the purchase of our products generally involves a significant commitment of capital and other resources by a customer. This commitment often requires significant technical review, assessment of competitive products, and approval at a number of management levels within the customer’s organization. Because of these issues, our sales cycle has ranged from six to nine months, and in some cases even longer, and it is very difficult to predict whether and when any particular license transaction might be completed. In addition, the downturn in the U.S. economy has caused some customers to increase budgetary controls or require additional management approvals within the customers’ organization prior to committing to significant capital purchases, either of which could result in an increased sales cycle.

Because a small number of customers have in the past accounted for a substantial portion of our revenues, our revenues could decline due to the loss or delay of a single customer order.

     Our ten largest transactions accounted for 35% of total revenues in the three months ended March 31, 2004. Our license agreements do not generally provide for ongoing license payments. Therefore, we expect that revenues from a limited number of customers will continue to account for a significant percentage of total revenues in future quarters. Our ability to attract new customers will depend on a variety of factors, including the reliability, security, scalability, breadth and depth of our products, and cost-effectiveness of our products. The loss or delay of individual orders could have a significant impact on revenues and operating results. Our failure to add new customers that make significant purchases of our product and services would reduce our future revenues.

If we are not successful in developing industry specific solutions based on Vitria:BusinessWare, our ability to increase future revenues could be harmed.

     We have developed and intend to continue to develop solutions based on Vitria:BusinessWare which incorporate business processes, connectivity and document transformations specific to the needs of particular industries, including the healthcare, telecommunications, financial services and manufacturing industries. This presents technical and sales challenges and requires collaboration with third parties, including system integrators and standard organizations, and the commitment of significant resources. Specific industries may experience economic downturns or regulatory changes that may result in delayed spending decisions by customers or require changes to our products. If we are not successful in developing these targeted solutions or these solutions do not achieve market acceptance, our ability to increase future revenues could be harmed.

     To date we have concentrated our sales and marketing efforts toward companies in the healthcare, telecommunications, financial services and manufacturing industries. Customers in these new vertical markets are likely to have different requirements and may require us to change our product design or features, sales methods, support capabilities or pricing policies. If we fail to successfully address these new vertical markets we may experience decreased sales in future periods.

Our products may not achieve market acceptance, which could cause our revenues to decline.

     Deployment of our products requires interoperability with a variety of software applications and systems and, in some cases, the ability to process a high number of transactions per second. If our products fail to satisfy these demanding technological objectives, our customers will be dissatisfied and we may be unable to generate future sales. Failure to establish a significant base of customer references will significantly reduce our ability to license our product to additional customers.

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Our markets are highly competitive and, if we do not compete effectively, we may suffer price reductions, reduced gross margins and loss of market share.

     The market for our products is intensely competitive, evolving and subject to rapid technological change. The intensity of competition is expected to increase in the future. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any one of which could significantly reduce our future revenues. Our current and potential competitors include ADP, Ascential Software, BEA, CCMS, CSC, IBM Corporation, IONA, Landacorp, McKesson, MedDecision, Microsoft Corporation, Netik, Pegasystems, ProxyMed, Quovadx, SeeBeyond Technology, SunGard, Sybase, TIBCO Software, TriZetto, ViPS, WebMD, webMethods and others. In the future, some of these companies may expand their products to provide or enhance existing business process management, business analysis and monitoring, and business vocabulary management functionality, as well as integration solutions for specific business problems. These or other competitors may merge to attempt the creation of a more competitive entity, or one that offers a broader solution than we provide. In addition, “in-house” information technology departments of potential customers have developed or may develop systems that provide for some or all of the functionality of our products. We expect that internally developed application integration and process automation efforts will continue to be a principal source of competition for the foreseeable future. In particular, it can be difficult to sell our products to a potential customer whose internal development group has already made large investments in and progress towards completion of systems that our product is intended to replace. Finally, we also face or may soon face direct and indirect competition from major enterprise software developers that offer integration products as a complement to their other enterprise software products. These companies may also modify their applications to be more easily integrated with other applications through web services or other means. Some of these vendors include Oracle, PeopleSoft, Siebel Systems and SAP AG.

     Many of our competitors have more resources and broader customer and partner relationships than we do. In addition, many of these competitors have extensive knowledge of our industry. Current and potential competitors have established or may establish cooperative relationships among themselves or with third-parties to offer a single solution and increase the ability of their products to address customer needs. Although we believe that our solutions generally compete favorably with respect to these factors, our market is relatively new and is evolving rapidly. We may not be able to maintain our competitive position against current and potential competitors, especially those with significantly greater resources.

Our revenues will likely decline if we do not develop and maintain successful relationships with system integrators.

     System integrators install and deploy our products and those of our competitors, and perform custom integration of systems and applications. Some system integrators engage in joint marketing and sales efforts with us. If these relationships fail, we will have to devote substantially more resources to the sales and marketing, and implementation and support of our product than we would otherwise have to, and our efforts may not be as effective as those of the system integrators. In many cases, these parties have extensive relationships with our existing and potential customers and influence the decisions of these customers. We rely upon these firms for recommendations of our product during the evaluation stage of the purchasing process, as well as for implementation and customer support services. A number of our competitors have strong relationships with these system integrators and, as a result, these system integrators may recommend competitors’ products and services. In addition, a number of our competitors have relationships with a greater number of these system integrators and, therefore, have access to a broader base of enterprise customers. Our failure to establish or maintain these relationships would significantly harm our ability to license and successfully implement our software product. In addition, we rely on the industry expertise and reach of these firms. Therefore, this failure would also harm our ability to develop industry-specific products. We are currently investing, and plan to continue to invest, significant resources to develop and maintain these relationships. Our operating results could be harmed if these efforts do not generate license and service revenues necessary to offset this investment.

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The cost and difficulty in implementing our product could significantly harm our reputation with customers, diminishing our ability to license additional products to our customers.

     Our products are often purchased as part of large projects undertaken by our customers. These projects are complex, time consuming and expensive. Failure by customers to successfully deploy our products, or the failure by us or third-party consultants to ensure customer satisfaction, could damage our reputation with existing and future customers and reduce future revenues. In many cases, our customers must interact with, modify, or replace significant elements of their existing computer systems. The costs of our products and services represent only a portion of the related hardware, software, development, training and consulting costs. The significant involvement of third parties, including system integrators, reduces the control we have over the implementation of our products and the quality of customer service provided to organizations which license our software.

If our products do not operate with the many hardware and software platforms used by our customers, our business may fail.

     We currently serve a customer base with a wide variety of constantly changing hardware, packaged software applications and networking platforms. If our products fail to gain broad market acceptance, due to their inability to support a variety of these platforms, our operating results may suffer. Our business depends, among others, on the following factors:

•		our ability to integrate our product with multiple platforms and existing, or legacy, systems and to modify our products as new versions of packaged applications are introduced;
•		the portability of our products, particularly the number of operating systems and databases that our products can source or target;
•		our ability to anticipate and support new standards, especially Internet standards;
•		the integration of additional software modules under development with our existing products; and
•		our management of software being developed by third parties for our customers or use with our products.

If we fail to introduce new versions and releases of our products in a timely manner, our revenues may decline.

     We may fail to introduce or deliver new products on a timely basis, if at all. In the past, we have experienced delays in the commencement of commercial shipments of our Vitria:BusinessWare products. To date, these delays have not had a material impact on our revenues. If new releases or products are delayed or do not achieve market acceptance, we could experience a delay or loss of revenues and cause customer dissatisfaction. In addition, customers may delay purchases of our products in anticipation of future releases. If customers defer material orders in anticipation of new releases or new product introductions, our revenues may decline.

Our products rely on third-party programming tools and applications. If we lose access to these tools and applications, or are unable to modify our products in response to changes in these tools and applications, our revenues could decline.

     Our programs utilize Java programming technology provided by Sun Microsystems. We also depend upon access to the interfaces, known as “APIs,” used for communication between external software products and packaged application software. Our access to APIs of third-party applications are controlled by the providers of these applications. If the application provider denies or delays our access to APIs, our business may be harmed. Some application providers may become competitors or establish alliances with our competitors, increasing the likelihood that we would not be granted access to their APIs. We also license technology related to the connectivity of our product to third-party database and other applications and we incorporate some third-party technology into our product offerings. Loss of the ability to use this technology, delays in upgrades, failure of these third parties to

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support these technologies, or other difficulties with our third-party technology partners could lead to delays in product shipment and could cause our revenues to decline.

We could suffer losses and negative publicity if new versions and releases of our products contain errors or defects.

     Our products and their interactions with customers’ software applications and IT systems are complex and, accordingly, there may be undetected errors or failures when products are introduced or as new versions are released. We have in the past discovered software errors in our new releases and new products after their introduction which has resulted in additional research and development expenses. To date, these additional expenses have not been material. We may in the future discover errors in new releases or new products after the commencement of commercial shipments. Since many customers are using our products for mission-critical business operations, any of these occurrences could seriously harm our business and generate negative publicity.

If we fail to attract and retain qualified personnel, our ability to compete will be harmed.

     We depend on the continued service of our key technical, sales and senior management personnel. None of these persons are bound by an employment agreement. The loss of senior management or other key research, development, sales and marketing personnel could have a material adverse effect on our future operating results. In addition, we must attract, retain and motivate highly skilled employees. We face significant competition for individuals with the skills required to develop, market and support our products and services. We cannot assure that we will be able to recruit and retain sufficient numbers of these highly skilled employees.

If we fail to adequately protect our proprietary rights, we may lose these rights and our business may be seriously harmed.

     We depend upon our ability to develop and protect our proprietary technology and intellectual property rights to distinguish our products from our competitor’s products. The use by others of our proprietary rights could materially harm our business. We rely on a combination of copyright, patent, trademark and trade secret laws, as well as confidentiality agreements and licensing arrangements, to establish and protect our proprietary rights. Despite our efforts to protect our proprietary rights, existing laws afford only limited protection. Attempts may be made to copy or reverse engineer aspects of our products or to obtain and use information that we regard as proprietary. Accordingly, there can be no assurance that we will be able to protect our proprietary rights against unauthorized third party copying or use. Furthermore, policing the unauthorized use of our products is difficult, and expensive litigation may be necessary in the future to enforce our intellectual property rights.

Our products could infringe the intellectual property rights of others causing costly litigation and the loss of significant rights.

     Software developers in our market will increasingly be subject to infringement claims as the number of products in different software industry segments overlap. Any claims, with or without merit, could be time-consuming, result in costly litigation, prevent product shipment or cause delays, or require us to enter into royalty or licensing agreements, any of which could harm our business. Patent litigation in particular has complex technical issues and inherent uncertainties. In the event an infringement claim against us is successful and we cannot obtain a license on acceptable terms or license a substitute technology or redesign our product to avoid infringement, our business would be harmed. Furthermore, former employers of our current and future employees may assert that our employees have improperly disclosed to us or are using confidential or proprietary information.

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Our significant international operations may fail to generate significant product revenues or contribute to our drive toward profitability, which could result in slower revenue growth and harm our business.

     We maintain international offices in countries including Australia, Brazil, Canada, France, Germany, Italy, Japan, Korea, Mexico, Singapore, Spain and The United Kingdom, and may establish additional international offices. During the three months ended March 31, 2004, 43% of our revenue was derived from international markets. There are a number of challenges to establishing operations outside of the United States and we may be unable to successfully generate significant international revenues. If we fail to successfully establish our products in international markets, we could experience slower revenue growth and our business could be harmed. It may be difficult to protect our intellectual property in certain international jurisdictions.

We are at risk of securities class action litigation due to our expected stock price volatility.

     In the past, securities class action litigation has often been brought against a company following a decline in the market price of its securities. This risk is especially acute for us because technology companies have experienced greater than average stock price volatility in recent years and, as a result, have been subject to, on average, a greater number of securities class action claims than companies in other industries. In November 2001, Vitria and certain of our officers and directors were named as defendants in a class action shareholder complaint. This litigation could result in substantial costs and divert management’s attention and resources, and could seriously harm our business. See Part II Item 1 “Legal Proceedings” for more information regarding this litigation.

We have implemented anti-takeover provisions which could discourage or prevent a takeover, even if an acquisition would be beneficial to our stockholders.

     Provisions of our amended and restated certificate of incorporation and bylaws, as well as provisions of Delaware law, could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:

•		establishment of a classified Board of Directors requiring that not all members of the Board of Directors may be elected at one time;
•		authorizing the issuance of “blank check” preferred stock that could be issued by our Board of Directors of directors to increase the number of outstanding shares and thwart a takeover attempt;
•		prohibiting cumulative voting in the election of directors, which would otherwise allow less than a majority of stockholders to elect director candidates;
•		limitations on the ability of stockholders to call special meetings of stockholders;
•		prohibiting stockholder action by written consent, thereby requiring all stockholder actions to be taken at a meeting of our stockholders; and
•		establishing advance notice requirements for nominations for election to the Board of Directors of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings

     Section 203 of the Delaware General Corporations Law and the terms of our stock option plans may also discourage, delay or prevent a change in control of Vitria. In addition, as of March 31, 2004, our executive officers, directors and their affiliates beneficially own approximately 37% of our outstanding common stock. This could have the effect of delaying or preventing a change of control of Vitria and may make some transactions difficult or impossible without the support of these stockholders.

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Item 4. CONTROLS AND PROCEDURES

     Evaluation of disclosure controls and procedures. Based on their evaluation as of March 31, 2004, our chief executive officer and chief financial officer have concluded that, our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) were sufficiently effective to ensure that the information required to be disclosed by us in this Quarterly Report on Form 10-Q was recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

     Changes in internal controls. There were no changes in our internal controls over financial reporting during our first fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

     Limitations on the effectiveness of controls. Our management, including our chief executive officer and chief financial officer, does not expect that our control systems will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Vitria have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, 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 a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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PART II
OTHER INFORMATION

Item 1. Legal Proceedings

     In November 2001, Vitria and certain of our officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, and captioned Kideys, et al., v. Vitria Technology, Inc., et al., Case No. 01-CV-10092. The plaintiffs allege that Vitria, certain of our officers and directors and the underwriters of our initial public offering (“IPO”), violated federal securities laws because Vitria’s IPO registration statement and prospectus contained untrue statements of material fact or omitted material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The plaintiffs seek unspecified monetary damages and other relief. Similar complaints were filed in the same court beginning in January 2001 against numerous public companies that first sold their common stock since the mid-1990s. All of these IPO-related lawsuits were consolidated for pretrial purposes before United States Judge Shira Scheindlin of the Southern District of New York. Defendants filed a global motion to dismiss the IPO-related lawsuits on July 15, 2002. On February 19, 2003, Judge Scheindlin issued a ruling denying in part and granting in part the Defendants’ motions to dismiss. On June 18, 2003, Vitria’s Board of Directors approved a resolution accepting a settlement offer from the plaintiffs according to the terms and conditions of a comprehensive Memorandum of Understanding negotiated between the plaintiffs and the issuer defendants. Under the terms of the settlement, the plaintiff class will dismiss with prejudice all claims against Vitria and our current and former directors and officers, and Vitria will assign to the plaintiff class or its designee certain claims that Vitria may have against the underwriters of our IPO. In addition, the tentative settlement guarantees that, in the event that the plaintiffs recover less than $1.0 billion in settlement or judgment against the underwriter defendants in the IPO-related lawsuits, the plaintiffs will be entitled to recover the difference between the actual recovery and $1.0 billion from the insurers for the Issuers. Although Vitria has approved this settlement proposal in principle, it remains subject to a number of procedural conditions, as well as formal approval by the court. If approved, there will be no cash or other payment from Vitria to the plaintiff class or any other parties.

     With the exception of the above lawsuit, we are not currently party to any other material pending legal proceedings, except routine legal proceedings arising in the ordinary course of and incidental to our business. We do not believe that these other proceedings, individually or collectively, will harm our business.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

     None.

Item 3. Defaults Upon Senior Securities

     None.

Item 4. Submission of Matters to a Vote of Security Holders

     None.

Item 5. Other Information

Consistent with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002, Vitria is responsible for disclosing the nature of the non-audit services

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approved by our Audit Committee during a quarter to be performed by Ernst & Young LLP, our independent auditor. Non-audit services are services other than those provided by Ernst & Young LLP in connection with an audit or a review of Vitria’s financial statements. During the quarter ended March 31, 2004 our Audit Committee did not approve any non-audit services to be performed by Ernst & Young LLP.

Item 6. Exhibits and Reports on Form 8-K

a) Exhibits

b) Reports on Form 8-K

Vitria filed a Current Report on Form 8-K, dated January 29, 2004, on January 29, 2004, reporting under “Item 12. Disclosure of Results of Operations and Financial Condition,” its result for the three months ended December 31, 2003.

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SIGNATURES

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

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EXHIBIT INDEX