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UNITED STATES

Form 10-Q

(Mark One)

[X]	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2004

OR

[ ]	Transition Report Pursuant to Section 13 or 15(d) of the

For the transition period from                     to                     

Commission File Number 000-27913

FreeMarkets, Inc.

Registrant’s telephone number, including area code: (412) 434-0500

      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 [ü]  No [ ]

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

      The number of shares of the registrant’s common stock outstanding as of the close of business on March 31, 2004 was 42,975,011.

FreeMarkets, Inc.

Form 10-Q

Index

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

FreeMarkets, Inc. and Subsidiaries

*	Summarized from audited December 31, 2003 balance sheet.

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

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FreeMarkets, Inc. and Subsidiaries

(1)	Stock compensation and warrant costs are attributable to the following operating expense categories:

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

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FreeMarkets, Inc. and Subsidiaries

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

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FreeMarkets, Inc. and Subsidiaries

Note 1.     Basis of Presentation

      The unaudited condensed consolidated financial statements have been prepared by FreeMarkets, Inc. and Subsidiaries (the “Company”) and reflect all adjustments (all of which are normal and recurring in nature) that, in the opinion of management, are necessary for a fair presentation of the interim periods presented. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire year ending December 31, 2004. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). The unaudited condensed consolidated financial statements and notes included herein should be read in conjunction with the Company’s audited consolidated financial statements and notes for the year ended December 31, 2003, included in the Company’s Annual Report on Form 10-K/ A filed with the SEC on April 29, 2004.

Note 2.     Merger with Ariba

      In January 2004, the Company announced a definitive agreement to merge with Ariba, Inc. (“Ariba”), a provider of Enterprise Spend Management products and services. Under terms of the agreement, shareholders of the Company’s common stock will receive 2.25 Ariba common shares and $2.00 in cash for each outstanding share of FreeMarkets. The transaction is subject to customary closing conditions, including regulatory review and approval by the stockholders of each company, and is expected to close in the latter part of the second quarter. Because the merger is subject to factors beyond the parties’ control, however, the Company cannot predict whether or when the merger will be completed. The Company has incurred to date merger-related costs of approximately $2.1 million related to financial advisor and other professional fees, which were all expensed in Q1 2004. Upon closing of the merger we become obligated to pay $2.5 million in merger-related investment banking fees.

Note 3.     Earnings Per Share

      The following potentially dilutive common shares were excluded because their effect was antidilutive:

      Options and warrants to purchase 9.6 million and 14.3 million shares of common stock were outstanding as of March 31, 2004 and 2003, respectively, but were not included in the computation of diluted EPS because the exercise price was greater than the average market price of the common shares.

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Notes to Condensed Consolidated Financial Statements — (continued)

      The following table illustrates the effect on earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”:

Note 4.     Stockholders’ Equity

      The components of comprehensive loss were as follows:

      The components of accumulated comprehensive income were as follows:

Note 5.     Acquisition, Goodwill and Other Intangible Assets

      In January 2004, the Company acquired the auction and services business of Covisint, an independent e-business provider for the global automotive industry for $16.3 million. The acquisition of Covisint is complimentary to the Company’s existing service offering. In accordance with SFAS No. 141, “Business Combinations,” the acquisition was accounted for as a purchase business combination. Accordingly, the purchase price allocations have been based upon an estimated fair value of net assets acquired. Covisint’s operating results

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Notes to Condensed Consolidated Financial Statements — (continued)

have been included in the Company’s Consolidated Results of Operations since the date of the acquisition. The purchase price of $17.0 million, including transaction costs of $697,000, was allocated as follows (in thousands):

      The Company’s methodology for allocating the purchase price to the customer contracts and technology acquired is based on a valuation performed by an independent third party. Goodwill will not be amortized, but will instead be subject to an annual impairment test. Goodwill resulting from the acquisition is expected to be tax deductible, but will be subject to a full valuation allowance as a result of the Company’s history of losses. Amortization of the technology acquired is being amortized over its estimated useful life of six months in cost of revenues in the Statement of Operations. Amortization of the customer contracts acquired is being amortized over the estimated useful lives of three to four years and is recorded as a reduction to gross revenues in the Statement of Operations.

      The following unaudited pro forma financial information presents the Company’s results of operations as if the acquisition of Covisint occurred at the beginning of the period presented. The unaudited pro forma financial information does not necessarily reflect the results of operations that would have occurred had the Company and Covisint constituted a single entity during such period.

      The following table sets forth an analysis of goodwill and other intangible assets as of March 31, 2004:

      The Company completed its annual test for impairment in Q1 2004, and concluded at that time that the Company did not have any impairment of goodwill based on the estimated fair value as determined by discounted cash flows.

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Notes to Condensed Consolidated Financial Statements — (continued)

Note 6.     Restructuring Charge

2004 Restructuring Plan

      In Q1 2004, the Company initiated two restructuring programs. These programs were focused on eliminating certain positions throughout its global workforce and re-assessing the Company’s facility needs. The following is a summary of these programs:

      In Q1 2004, the Company executed a restructuring plan resulting in the elimination of 69 positions in its global workforce. This represented approximately 7% of total employees. The Company recorded a restructuring charge of $2.0 million in Q1 2004 covering these severance costs. The remaining liability for employee severance and termination benefit costs of $131,000 will be paid in Q2 2004.

      Also in Q1 2004, the Company re-assessed its global headquarters office space in Pittsburgh, Pennsylvania, and ceased using one of the floors it leases through May 2010, as well as closed two domestic offices. The Company recorded a restructuring charge of $2.8 million in Q1 2004. The Company intends to sub-lease the floor in its global headquarters, and estimated sublease income based on current real estate market conditions.

      The 2004 facility reduction plan includes $2.4 million of estimated future obligations for non-cancelable lease payments generated by exiting an excess leased floor and two domestic offices, $331,000 for the impairment of property and equipment (primarily leasehold improvements) that were no longer in use and $81,000 for restructuring plan implementation costs. The accrual for lease costs (net of anticipated sub-lease proceeds) will be paid over the lease term though May 2010. As of March 31, 2004, $543,000 of the $2.3 million accrual will be paid in the twelve months from March 31, 2004 and is therefore classified as a current liability in the Company’s consolidated balance sheet.

      The Company is continuing to evaluate its office space requirements at its headquarters, and as a result, the Company may incur additional lease-related charges in the future.

2003 Restructuring Plans

      Throughout 2003, the Company initiated three restructuring programs. These programs were focused on eliminating certain positions throughout its global workforce, re-assessing the Company’s facility needs and consolidating European operations to create a more profitable and efficient business. The following is a summary of these programs:

      In Q1 2003, the Company executed a restructuring plan resulting in the elimination of 79 positions in its global workforce. This represented approximately 7% of total employees. The Company recorded a restructuring charge of $1.8 million in Q1 2003 covering these severance costs. The liability for employee severance and termination benefit costs related to this activity was paid by December 31, 2003.

      Also in 2003, the Company re-assessed its global headquarters office space in Pittsburgh, Pennsylvania, and ceased using two of the floors it leases through May 2010. The Company recorded a restructuring charge of $3.0 million and $2.0 million in Q1 2003 and Q4 2003, respectively. The Company intends to sub-lease these floors, and estimated sublease income based on prevailing real estate market conditions.

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Notes to Condensed Consolidated Financial Statements — (continued)

      The facility reduction plan includes $2.9 million and $1.8 million of estimated future obligations for non-cancelable lease payments generated by exiting excess leased floors in Q1 2003 and Q4 2003, respectively, and $89,000 and $282,000 for the impairment of property and equipment (leasehold improvements) that were no longer in use in Q1 2003 and Q4 2003, respectively. The accrual for lease costs (net of anticipated sub-lease proceeds) will be paid over the lease term though May 2010. As of March 31, 2004, $688,000 of the $4.2 million accrual will be paid in the twelve month period from March 31, 2004, and is therefore classified as a current liability in the Company’s consolidated balance sheet.

      In Q3 2003, in order to better serve the Company’s customers and enable it to create a more leveraged, profitable and efficient business across Europe, the Company initiated a restructuring plan resulting in the net elimination of 74 positions in its European business. There were 105 positions eliminated with the closing of the Brussels facility, offset by 31 positions added to the existing European facilities in London, Paris and Frankfurt. The Company recorded a restructuring charge of $3.2 million in Q3 2003 covering these severance costs and legal fees. As of March 31, 2004, the severance costs have been paid in accordance with local employment laws.

      In Q4 2003, the Company recorded an additional charge of $4.2 million. This charge includes $847,000 of severance costs, $1.8 million of estimated future obligations for non-cancelable lease payments generated by exiting the Brussels facility, $1.2 million for the impairment of property and equipment (primarily leasehold improvements) that were no longer in use, and $308,000 for restructuring plan implementation costs, primarily comprised of legal and other professional fees. The Company intends to sub-lease the facility, and estimated sublease income based on prevailing real estate market conditions. The Company expects to pay the remaining restructuring accrual relating to severance and implementation costs in the amount of $617,000 in Q2 2004. The accrual for lease costs (net of anticipated sub-lease proceeds) will be paid over the lease term through August 2006. As of March 31, 2004, $702,000 of the $1.1 million accrual for lease costs will be paid in the next twelve months, and is therefore classified as a current liability in the Company’s consolidated balance sheet.

      In Q1 2004, as a result of substantially completing the liquidation of the investment in the Belgium entity, the Company recorded a benefit of $617,000 relating to the amount accumulated in the translation component of equity.

      The following table sets forth an analysis of the restructuring accrual activity for the period ended March 31, 2004:

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Notes to Condensed Consolidated Financial Statements — (continued)

Note 7.     Securities Class Action Complaints

      Since April 27, 2001, eleven securities fraud class action complaints have been filed against the Company and two executive officers in federal court in Pittsburgh, Pennsylvania. The complaints, all of which assert the same claims, stem from the Company’s announcement on April 23, 2001 that, as a result of discussions with the SEC, the Company was considering amending its 2000 financial statements for the purpose of reclassifying fees earned by the Company under a service contract with Visteon. All of the cases have been consolidated into a single proceeding. On October 30, 2001, the Company filed a motion seeking to dismiss all of the cases in their entirety. On January 17, 2003, the Court denied the motion to dismiss. On March 10, 2004, the court certified the case as a class action. The case is now in the discovery phase. In addition, on September 24, 2001, an individual claiming to be a FreeMarkets shareholder filed a shareholder’s derivative action, nominally on behalf of FreeMarkets, against all of the Company’s directors and certain of its executive officers. FreeMarkets is also named as a nominal defendant. The suit is based on the same facts alleged in the foregoing securities fraud class actions. The Company believes that the plaintiffs’ allegations are without merit and it intends to defend these claims vigorously.

      Since July 31, 2001, several securities fraud class action complaints have been filed in the United States District Court for the Southern District of New York alleging violations of the securities laws in connection with the Company’s December 1999 initial public offering (“IPO”). In four of the complaints, the Company and certain of its officers are named as defendants, together with the underwriters that are the subject of the plaintiffs’ allegations. Each of these cases has been consolidated for pretrial purposes into an earlier lawsuit against the underwriters of the Company’s IPO. In addition, the cases have been consolidated for pretrial purposes with approximately 1,000 other lawsuits filed against other issuers, their officers, and underwriters of their initial public offerings. On April 19, 2002, a consolidated amended class action complaint (the “Consolidated Complaint”) was filed. The Consolidated Complaint alleges claims against the Company and seven of its officers and/or directors, as well as seven investment banking firms who either served as underwriters or are successors in interest to underwriters of the Company’s IPO. The Consolidated Complaint alleges that the prospectus used in the Company’s IPO contained material misstatements or omissions regarding the underwriters’ allocation practices and compensation in connection with the IPO and also alleges that the underwriters manipulated the aftermarket for the Company’s stock. Damages in an unspecified amount are sought, together with interest, costs and attorney’s fees. The defendants filed a motion to dismiss the Consolidated Complaint. On February 19, 2003, the court denied the Company’s motion to dismiss. On June 25, 2003, a Special Committee of the Board of Directors of the Company approved a proposed settlement of the litigation under terms set forth in a memorandum of understanding, and authorized the Company to enter into a definitive settlement agreement to be prepared in accordance with the memorandum of understanding. The anticipated settlement will be subject to court approval following notice to class members and a fairness hearing. Based on the memorandum of understanding, the Company believes that the anticipated settlement will have no material effect on the Company.

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      The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes contained in this Quarterly Report on Form 10-Q (“Form 10-Q”).

      Certain statements contained in this Form 10-Q constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different than any expressed or implied by these forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue,” or the negative of these terms or other comparable terminology. Furthermore, in addition to the risks described in this Form 10-Q, we are subject to specific risks and uncertainties related to our business model, strategies, markets and legal and regulatory environment. For a detailed discussion of some of these risks, please see the risk factors included in our Annual Report on Form 10-K/ A for the year ended December 31, 2003, as filed with the SEC on April 29, 2004.

Overview

      FreeMarkets provides software and service solutions to help companies improve their sourcing and global supply management processes and enhance the capabilities of their supply management organizations. Our customers are buyers of industrial parts, raw materials, commodities and services. As of March 31, 2004, we serve our customers from 17 locations in 13 countries on five continents. Our team members provide service to customers in more than 35 languages through operations centers in Pittsburgh and Singapore.

      Since inception, FreeMarkets has provided software and services to help companies identify savings, enhance their sourcing efficiency and achieve their strategic sourcing goals by enabling them to source goods and services in our online markets. In providing these services, we work with our customers to identify and screen suppliers and to assemble a request for quotation that provides detailed, clear and consistent information for suppliers to use in our online markets. Our web-based technology enables suppliers from around the world to submit bids for our customers’ purchase orders in real-time interactive competition featuring “downward price” dynamic bidding. While we have provided this technology-enhanced service to buyers since 1995, we began to describe it using the “FullSource” name in 2001. In 2001, we also introduced our QS solution, which enables customers to conduct their own sourcing projects, including running their own online markets. During 2002 and 2003, we introduced a number of new solution offerings to expand beyond sourcing to address a broader set of supply management activities. Our development of a broader set of solutions is part of a strategic transition from a company that offers a single technology-enhanced service to one with multiple software and service solutions. These activities include supply analysis and strategy, spend requirements management, sourcing, supplier development and supplier relationship management. We refer to these activities as Global Supply Management, or GSM.

      Our solutions combine software, services and information to address the GSM market. These solutions are ultimately designed to help companies lower costs and reduce their supply risks.

      In January 2004, we announced a definitive agreement to merge with Ariba, Inc. (“Ariba”), a provider of Enterprise Spend Management products and services. Under terms of the agreement, shareholders of our common stock will receive 2.25 Ariba common shares and $2.00 in cash for each outstanding share of FreeMarkets. The transaction is subject to customary closing conditions, including regulatory review and approval by the stockholders of each company, and is expected to close in the latter part of the second quarter. Because the merger is subject to factors beyond the parties’ control, however, we cannot predict whether or when the merger will be completed.

      Also in January 2004, we acquired the auction and services business of Covisint, an independent e-business service provider for the global automotive industry, for $16.3 million.

      Also in January 2004, we executed a restructuring plan resulting in the elimination of 69 positions in our global workforce. Additionally, in February 2004, we evaluated our office space in Pittsburgh, Pennsylvania, and

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Overview of Q1 2004 Financial Results

      Our operating results during Q1 2004 should be considered within the context of our continuing transition to a provider of multiple software and service solutions, the restructuring plan implemented during the quarter and our merger announcement with Ariba in January 2004. Net revenues in Q1 2004 decreased $4.5 million, or 13% from Q1 2003 due to a combination of factors, including a change in the mix of products and services deployed by our customers, partially offset by revenue from contracts acquired from Covisint, which comprise approximately 10% of Q1 2004 net revenues. The decrease is also due to the merger announcement, which has caused a number of existing customers to either defer their contract renewal decisions or make smaller renewal commitments. We believe that the announcement has lengthened our sales cycles with potential customers, who are deferring their purchasing decisions because of concerns regarding our future solutions roadmap.

      Total operating expenses in Q1 2004 declined $3.5 million, or 7% from Q1 2003 primarily due to reduced compensation costs (down $2.2 million on a 10% decrease in average number of employees), depreciation expense (down $1.7 million) and cost cutting measures in discretionary spending such as marketing and advertising (down $1.4 million). The decline in operating expenses was offset by $2.1 million in Ariba merger-related costs. We ended Q1 2004 with 896 employees versus 992 at the end of Q1 2003. Finally, total cash and investments of $107.8 million at the end of Q1 2004 was $28.9 million less than the $136.7 million at the end of Q4 2003. The decrease is primarily due to the $14.8 million cash paid for the acquisition of Covisint’s auction services business and related transaction costs in January 2004 and the $13.1 million net loss in Q1 2004.

Critical Accounting Policies

      The accompanying 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 generally accepted accounting principles in the United States of America (“US GAAP”). 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 disclosure of contingent assets and liabilities. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We base our estimates and judgments on historical experience and all available information. However, future events are subject to change, and the best estimates and judgments routinely require adjustment. US GAAP requires us to make estimates and judgments in several areas, including those related to recording various accruals (such as incentive compensation and restructuring costs), income taxes, the useful lives of long-lived assets such as property and equipment and potential losses from contingencies and litigation. We believe the policies discussed below are the most critical to our financial statements because they are affected significantly by management’s judgments, assumptions and estimates.

      We generate revenues under service and access agreements with our customers. While the vast majority of our agreements contain standard business terms and conditions, there are many agreements that contain complex terms and conditions. As a result, we are required to evaluate the scope and significance of contract provisions in order to determine the appropriate accounting. In addition, our revenue recognition policy requires an assessment as to whether the collectibility is probable, which inherently requires us to evaluate the creditworthiness of our customers.

      For all offerings, the Company recognizes revenue when all of the following criteria are met as set forth in Staff Accounting Bulletin No. 101:

	(1)	Persuasive evidence of an arrangement exists (contract is signed and legally binding),
	(2)	Services have been rendered or access has been provided (with no future obligations),

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	(3)	The fee is fixed and determinable (amount is known and not contingent upon future events), and
	(4)	Collectibility is probable (high degree of confidence that the customer will pay).

      Our FullSource service agreements typically provide revenues from fixed monthly fees, and may also include performance incentive payments based on volume and/or savings. The structure in a particular service agreement may vary, depending upon the needs of our customer and the conventional practices in the supply market where our customer obtains its materials, commodities or services. The fees that we receive are for the use of our technology, supplier and supply market information, sourcing operations staff and facilities. Negotiated fees vary by customer, and reflect both the anticipated volume and the staffing, expertise and technology we anticipate committing to complete the services requested by our customers. We recognize revenues from our fixed monthly FullSource fees ratably as we provide access to our services over the related contract period. Our agreements range in length from a few months to as many as five years. At any given time, we have agreements of varying lengths with staggered expirations. Some of our agreements permit early termination without cause by our customers without penalty. The customers related to the acquisition of Covisint are served using legacy technology that will be transitioned over to FreeMarkets technology during 2004. The services provided are similar in nature to that of our FullSource offering, and therefore, substantially all of their revenues are allocated to FullSource and recognized in a manner consistent with our FullSource service contracts.

      Many of the service agreements for our FullSource offering include performance incentive payments that are contingent upon our customer achieving specific volumes and/or savings, as set forth in the respective agreements. We recognize these revenues as the thresholds are achieved. If our FullSource market volume grows, the revenues attributable to these incentive payments may also grow in terms of absolute dollars, but not necessarily as a percentage of revenues.

      The agreements for our QS hosted technology offering provide for revenues from fixed monthly access fees. The fees that we receive are for providing access to our technology and for add-on services. Negotiated access fees for our QS offering vary by customer, and reflect the anticipated number of customer users and add-on services. We recognize revenues from our QS offering as we provide access or add-on services.

      The agreements for our ES, Spend Visibility and Supplier Implementation solutions provide for revenues from fixed monthly access fees. The fees that we receive are for providing access to our technology and for certain services. We recognize revenues from these new offerings as we provide access or services.

      The majority of our customer agreements include multiple service offerings. Each service offering consists of a single element. In determining the appropriate amount of revenue to be recognized for each offering, we evaluate whether these arrangements contain separate units of accounting. This determination is based on whether: the delivered item has value to the customer on a standalone basis (that is, if it is sold separately by any vendor or the customer could resell the deliverable); there is objective and reliable evidence of fair value of the undelivered items in the arrangement; and if the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the vendor. In instances where all of these conditions are satisfied, we recognize revenue for the offerings that have been delivered to the customer based on the relative fair value of the delivered item when compared to the total arrangement considered, subject to certain limitations. The fair value for each element is established based on the sales price charged when the same element is sold separately.

      Reimbursements, including those related to travel and other out-of-pocket expenses, are included in revenues, and an equivalent amount of reimbursable expenses are included in cost of revenues.

      We evaluate the collectibility of our accounts receivable based on a combination of factors. In cases where we are aware of circumstances that may impair a customer’s ability to meet its financial obligations to us, we record a specific allowance against amounts due to us. For all customers, we recognize allowance for doubtful accounts based on the length of time the receivables are past due, the current business environment and our historical experience. If the financial condition of our customers deteriorates or if economic conditions worsen, additional allowances may be required in the future.

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      SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”, gives companies the option to adopt the fair value method for expense recognition of employee stock options or to continue to account for employee stock options using the intrinsic value method, as outlined under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”. We have elected to continue to apply the intrinsic value method to account for employee stock options and disclose the pro forma effect as if the fair value method had been applied in the notes to our consolidated financial statements.

      Lease abandonment costs for abandoned facilities are estimated to include the impairment of leasehold improvement and remaining lease liabilities, offset by estimated sublease income, if appropriate. Estimates related to sublease costs and income are based on assumptions regarding the period required to locate and contract with suitable sub-lessees. Each quarter, we review these estimates, and to the extent that our assumptions change, the ultimate restructuring expenses for these abandoned facilities could vary from current estimates. In 2003, we recorded a $6.5 million charge for the closing of our Brussels facility and abandonment of two leased floors in our global headquarters office space in Pittsburgh. In Q1 2004, we recorded a $2.4 million charge for the abandonment of one additional leased floor in our Pittsburgh facility, as well as closed two domestic offices.

Treatment of Visteon Fees

      In April 2000, we entered into a five-year agreement with Visteon under which we agreed to provide our FullSource technology-enhanced services, and Visteon agreed to pay us fixed monthly fees plus the possibility of additional variable fees based on performance. We have also received marketing and public relations benefits as a result of our relationship with Visteon. At the time we executed this service agreement, we granted to Visteon a warrant for 1.75 million shares of our common stock, with an exercise price of $.01 per share. The warrant was valued at $95.5 million using the Black-Scholes pricing model at the date of the grant in April 2000. We exclude from our revenues the fees we earn under our service agreement with Visteon; however, our cost of revenues includes the costs that we incur in serving Visteon under this agreement.

      The service agreement with Visteon expires in April 2005, and because we have classified the fees we earn under this agreement as payment for the warrant, we do not expect to recognize revenues under this agreement during the remainder of its term.

      Below is a reconciliation of net revenues under generally accepted accounting principles with net revenues plus the fees we earn under our service contract with Visteon:

Treatment of Covisint Acquisition

      In January 2004, we acquired the auction and services business of Covisint, an independent e-business service provider for the global automotive industry, for $16.3 million. As a result of this transaction, the selling shareholders of Covisint became FreeMarkets customers through our assumption of those shareholders’ existing service agreements with Covisint. We are recording the amortization of the fair value of those customer contracts as a reduction in revenue. We recorded a $9.1 million customer intangible asset as a result of a third-party valuation of those contracts, which is being amortized over three to four years. During Q1 2004, we recorded $577,000 of amortization as a reduction in revenue.

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Results of Operations

      The following table sets forth condensed consolidated statement of operations data as a percentage of revenues for the periods indicated:

*	Stock compensation and warrant costs have not been allocated to research and development and sales and marketing.

Three Months Ended March 31, 2004 and 2003

      All references to “Q1 2004” and “Q1 2003” are for the three months ended March 31, 2004 and 2003, respectively.

Net revenues

      Net revenues decreased 13% from $34.5 million in Q1 2003 to $30.0 million in Q1 2004. The decrease in net revenues is due to a combination of factors, including a change in the mix of products and services deployed by our customers, partially offset by revenue from contracts acquired from Covisint, which comprise approximately 10% of Q1 2004 net revenues. The decrease is also due to the merger announcement, which has caused a number of existing customers to either defer their contract renewal decisions or make smaller renewal commitments. We believe that the announcement has lengthened our sales cycles with potential customers, who are deferring their purchasing decisions because of concerns regarding our future solutions roadmap.

      In 2003 and early 2004, several large customers renewed their FullSource service agreements at lower market volumes than the volumes provided in previously existing agreements, resulting in 34% lower net revenues from our FullSource offering in Q1 2004 compared to Q1 2003. In addition, with the introduction of our less-costly QS solution in early 2001 and several other new offerings in late 2002 and early 2003, many FullSource-only customers have expanded their use of our solutions to include a broader mix of FullSource, QS and related offerings. As customers gain experience with our sourcing solutions, certain entities have migrated a portion of their sourcing requirements to our self-service technologies. In some cases, increased sales of additional solutions to existing customers have resulted in lower total net revenues due to this migration to our self-service technologies. For instance, our transition to a multiple-solutions company over the past two years is a result of leveraging our knowledge and service capabilities to grow our other solutions, most notably QS, ES and Consulting. These other solutions combined delivered 46% more net revenues in Q1 2004 compared to Q1 2003, partially offsetting the decline in FullSource.

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      To illustrate this migration, our top 20 customers in Q1 2003, which accounted for approximately 60% of total revenues, reduced their use of FullSource by $10.4 million in Q1 2004 as compared with Q1 2003. Those same 20 customers migrated a portion of their sourcing solutions needs to our QS and other less costly offerings over the same time period, resulting in an increase from those customers for these solutions of $1.9 million, or 66%. However, the growth in those less-costly solutions and the acquisition of Covisint in Q1 2004 did not offset the decline in revenues from our FullSource solution.

Operating costs and expenses

      Cost of revenues. Cost of revenues decreased from $18.4 million, or 53% of revenues in Q1 2003 to $16.9 million, or 56% of revenues in Q1 2003. The increase in cost of revenues as a percentage of revenues from Q1 2003 to Q1 2004 was primarily the result of the 13% decrease in revenues from Q1 2003 to Q1 2004, partially offset by an 8% overall decrease in cost of revenues. The decrease in absolute dollar amounts from Q1 2003 to Q1 2004 is primarily attributable to the following: (1) decrease in compensation and benefits expense in the amount of $1.2 million, primarily due to a 9% decrease in the average number of account management, global sourcing services and market operations staff; (2) reduced overhead in the amount of $1.1 million, primarily comprised of reduced depreciation expense in the amount of $936,000; and (3) reduced bad debt expense in the amount of $501,000 due to the write-off of approximately $900,000 due from a single customer in Q1 2003. The decrease in cost of revenues in absolute dollars is partially offset by an increase in professional and consulting costs in the amount of $1.4 million associated with serving contracts acquired in the Covisint acquisition in January 2004. Cost of revenues includes the costs we incur in performing our obligations under the Visteon service contract, even though the fees we earn under that contract are excluded from revenues.

      Research and development. Research and development costs decreased from $6.5 million, or 19% of revenues in Q1 2003, to $5.8 million, or 19% of revenues in Q1 2004. The decrease was primarily related to the following: (1) reduced overhead in the amount of $718,000, primarily comprised of reduced depreciation expense; and (2) reduced consulting fees in the amount of $329,000. The decrease in research and development costs is partially offset by a $400,000 charge in Q1 2004 associated with a legal settlement with a former vendor.

      Sales and marketing. Sales and marketing costs decreased from $9.4 million, or 27% of revenues in Q1 2003, to $8.3 million, or 28% of revenues in Q1 2004. The decrease is primarily attributable to cost cutting measures in discretionary spending in Q1 2004 such as marketing and advertising in the amount of $1.4 million.

      General and administrative. General and administrative costs decreased from $6.1 million, or 18% of revenues in Q1 2003, to $4.0 million, or 13% of revenues in Q1 2004. The decrease from Q1 2003 to Q1 2004 is primarily attributable to the following: (1) reduced compensation and benefits expense in the amount of $855,000 due to a 28% decrease in the average number of personnel in the areas of human resources, finance and facilities management in Q1 2004 compared to Q1 2003; and (2) reduced overhead in the amount of $761,000, primarily comprised of reduced depreciation expense in the amount of $245,000.

      Stock compensation and warrant costs. In April 2000, we recorded $95.5 million of unearned warrant costs related to a warrant granted to Visteon. This value was calculated using the Black-Scholes pricing model at the date of grant and is being amortized over a five-year period ending April 2005. In each of Q1 2003 and Q1 2004, $4.8 million was amortized related to this warrant, with $2.8 million and $2.6 million in Q1 2003 and Q1 2004, respectively, reflected as a reduction to our revenues (reducing the revenues under the Visteon service contract to zero) and $2.0 million and $2.2 million in Q1 2003 and Q1 2004, respectively, as stock compensation and warrant costs.

      Ariba merger-related costs. In January 2004, we announced a definitive agreement to merge with Ariba, Inc. (“Ariba”), a provider of Enterprise Spend Management products and services. In Q1 2004, we incurred merger-related costs of $2.1 million related to our financial advisor and other professional fees.

      Restructuring charges. Throughout 2003 and Q1 2004, we initiated several restructuring programs that were focused on eliminating certain positions throughout our global workforce, re-assessing our facility needs and consolidating European operations to create a more profitable and efficient business. We expect to generate annual savings of approximately $19.5 million as a result of these programs, of which $17.3 million relates to compensation and benefits and $2.2 million relates to rent and depreciation. Annual savings are expected to be

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2003 Restructuring plans

      In Q1 2003, we executed a restructuring plan resulting in the elimination of 79 positions in its global workforce. This represented approximately 7% of total employees. We recorded a restructuring charge of $1.8 million in Q1 2003 covering these severance costs. The liability for employee severance and termination benefit costs related to this activity was paid by December 31, 2003; and therefore no incremental liquidity resources will be utilized in the future to implement this plan. Annual savings from this plan are approximately $6.4 million, of which approximately $1.6 million was realized in compensation and benefit costs of our Q1 2004 operating results. Annual savings for this plan are expected to be realized in the following income statement line items: $3.7 million in cost of revenues; $1.0 million in research and development; $1.0 million in sales and marketing; and $642,000 in general and administrative.

      Also in 2003, we re-assessed our global headquarters office space in Pittsburgh, Pennsylvania, and ceased using two of the floors we lease through May 2010. We recorded a restructuring charge of $3.0 million and $2.0 million in Q1 2003 and Q4 2003, respectively. We intend to sub-lease these floors, and estimated sublease income based on current real estate market conditions.

      The facility reduction plan includes $2.9 million and $1.8 million of estimated future obligations for non-cancelable lease payments generated by exiting excess leased floors in Q1 2003 and Q4 2003, respectively, and $89,000 and $282,000 for the impairment of property and equipment (leasehold improvements) that were no longer in use in Q1 2003 and Q4 2003, respectively. The accrual for lease costs (net of anticipated sub-lease proceeds) will be paid over the lease term though May 2010. As of March 31, 2004, $688,000 of the $4.2 million accrual will be paid in the twelve month period from March 31, 2004, and is therefore classified as a current liability in the Company’s consolidated balance sheet. The $688,000 current liability also represents our expected liquidity requirements in the next twelve months to continue the implementation of this plan. Annual savings from this plan are $717,000 of which $179,000 was realized in rent and depreciation costs of our Q1 2004 operating results. Annual savings for this plan are expected to be realized in the following income statement line items: $447,000 in cost of revenues; $123,000 in research and development; $123,000 in sales and marketing; and $24,000 in general and administrative.

      In Q3 2003, in order to better serve our customers and enable us to create a more leveraged, profitable and efficient business across Europe, we initiated a restructuring plan resulting in the net elimination of 74 positions in our European business. There were 105 positions eliminated with the closing of our Brussels facility, offset by 31 positions added to our existing European facilities in London, Paris and Frankfurt. We recorded a restructuring charge of $3.2 million in Q3 2003 covering these severance costs and legal fees. As of March 31, 2004, the severance costs have been paid in accordance with local employment laws; and therefore no incremental liquidity resources will be utilized in the future to implement this portion of the Europe plan.

      In Q4 2003, we recorded an additional charge of $4.2 million. This charge includes $847,000 of severance costs, $1.8 million of estimated future obligations for non-cancelable lease payments generated by exiting the Brussels facility, $1.2 million for the impairment of property and equipment (primarily leasehold improvements) that were no longer in use, and $308,000 for restructuring plan implementation costs, primarily comprised of legal and other professional fees. We intend to sub-lease the facility, and estimated sublease income based on current real estate market conditions. We expect to pay the remaining restructuring accrual relating to severance and implementation in the amount of $617,000 in Q2 2004. The accrual for lease costs (net of anticipated sub-lease proceeds) will be paid over the lease term through August 2006. As of March 31, 2004, $702,000 of the

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      In Q1 2004, as a result of substantially completing the liquidation of the investment in the Belgium entity, we recorded a benefit of $617,000 relating to the amount accumulated in the translation component of equity.

2004 Restructuring plans

      In Q1 2004, we executed a restructuring plan resulting in the elimination of 69 positions in our global workforce. This represented approximately 7% of total employees. We recorded a restructuring charge of $2.0 million in Q1 2004 covering these severance costs. The remaining liability for employee severance and termination benefit costs of $131,000 will be paid in Q2 2004, which represents our expected liquidity requirements to conclude this plan. Annual savings from this plan are approximately $6.1 million, of which approximately $950,000 was realized in compensation and benefit costs of our Q1 2004 operating results. Annual savings from this plan are expected to be realized in the following income statement line items: $2.0 million in cost of revenues; $2.1 million in research and development; $1.0 million in sales and marketing; and $853,000 in general and administrative.

      Also in Q1 2004, we re-assessed our global headquarters office space in Pittsburgh, Pennsylvania, and ceased using one of the floors we lease through May 2010, as well as closed two domestic offices. We recorded a restructuring charge of $2.8 million in Q1 2004. We intend to sub-lease the floor in our global headquarters, and estimated sublease income based on current real estate market conditions.

      The 2004 facility reduction plan includes $2.4 million of estimated future obligations for non-cancelable lease payments generated by exiting an excess leased floor and two domestic offices, $331,000 for the impairment of property and equipment (primarily leasehold improvements) that were no longer in use and $81,000 for restructuring plan implementation costs. The accrual for lease costs (net of anticipated sub-lease proceeds) will be paid over the lease term though May 2010. As of March 31, 2004, $543,000 of the $2.3 million accrual will be paid in the twelve month period from March 31, 2004 and is therefore classified as a current liability in our consolidated balance sheet. The $543,000 current liability also represents our expected liquidity requirements in the next twelve months to continue the implementation of this plan. Annual savings from this plan are $464,000, of which $44,000 was realized in rent and depreciation costs of our Q1 2004 operating results. Annual savings from this plan are expected to be realized in the following income statement line items: $269,000 in cost of revenues; $74,000 in research and development; $74,000 in sales and marketing; and $47,000 in general and administrative.

      We are continuing to evaluate our office space requirements at our headquarters, and as a result, we may incur additional lease-related charges in the future.

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      The following table sets forth an analysis of the restructuring accrual activity for the period ended March 31, 2004: