MICROMUSE INC - 10-Q Quarterly Report

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 rule 12b-2 of the Exchange Act). Yes ¨ No x

74,969,725 shares of Common Stock, $0.01 par value, were outstanding as of January 31, 2003

The condensed consolidated financial statements are the unaudited historical financial statements of Micromuse Inc. and subsidiaries (the “Company”) and reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of interim period results. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K as filed with the Securities and Exchange Commission on December 23, 2002. The September 30, 2002, consolidated balance sheet included herein was derived from audited financial statements, but does not include all disclosures, including notes, required by generally accepted accounting principles.

The results of operations for the current interim period are not necessarily indicative of results to be expected for the entire current year or other future interim periods.

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

The Company considers all highly liquid instruments with an original maturity of three months or less to be cash equivalents.

Basic per share amounts are calculated using the weighted-average number of common shares outstanding during the period. Diluted per share amounts are calculated using the weighted-average number of common shares outstanding during the period and, when dilutive, the weighted-average number of potential common shares from the exercise of outstanding options and warrants to purchase common stock using the treasury stock method. Excluded from the computation of diluted loss per share for the quarter ended December 31, 2002 were options to acquire 15.2 million shares of common stock and a warrant to acquire 54,321 shares of common stock at $5.42 per share because their effect would be anti-dilutive. Excluded from the computation of diluted earnings per share for the quarter ended December 31, 2001 were options to acquire 9.5 million shares of common stock because their effect would be anti-dilutive. A reconciliation of the numerators and denominators used in the basic and diluted net income per share amounts follows (in thousands):

One third-party distributor customer accounted for approximately 20% and 15% of revenues for the quarters ended December 31, 2002 and 2001, respectively. Another third party distributor also accounted for approximately 15% of revenues for the quarter ended December 31, 2001, primarily related to a transaction with one end-user customer. One end-user customer accounted for 17% of revenues for the quarter ended December 31, 2002.

Accounts receivable includes an allowance for doubtful accounts of $3.8 million and $3.7 million as of December 31, 2002 and September 30, 2002, respectively.

The only component of accumulated other comprehensive loss is net foreign currency translation adjustments. Other comprehensive loss, net of tax, for the quarters ended December 31, 2002 and 2001 was $723,000 and $661,000, respectively.

The Company’s chief operating decision-maker is considered to be the Company’s Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a consolidated basis accompanied by certain geographic information for purposes of making operating decisions and assessing financial performance. Therefore, the Company operates as a single operating segment: service and business assurance software.

The Company markets its products primarily from the United States. International sales are primarily to customers in the United Kingdom and continental Europe. Information regarding regional revenues, which are based on the location of the end-user, and operations in different geographic regions is as follows (in thousands):

In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. SFAS No. 142 changes the accounting for goodwill from an amortization method to an impairment-only approach. Goodwill will be tested annually and whenever events or circumstances occur indicating that goodwill might be impaired. Amortization of goodwill recorded for business combinations consummated prior to July 1, 2001 will cease, and intangible assets acquired prior to July 1, 2001 that do not meet the criteria for recognition under SFAS No. 141, Business Combinations, will be reclassified to goodwill. The Company adopted SFAS No. 142 on October 1, 2002. Upon adoption, approximately $16.3 million of goodwill will no longer be amortized but will be tested annually for impairment. In the quarter ended March 31, 2003, the Company will perform its transitional goodwill impairment test required under SFAS No. 142.

Summarized below are the effects on net income (loss) and net income (loss) per share data, if the Company had followed the provisions of SFAS No. 142 for all periods presented (in thousands, except per share amounts):

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Asset’s, which is effective for fiscal years beginning after December 15, 2001 and early adoption is permitted. SFAS No. 144 supersedes certain provisions of APB Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (APB 30), and supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. Although SFAS No. 144 supersedes SFAS No. 121 and the provisions of APB 30 regarding the accounting and reporting of the disposal of a segment of a business, it retains many of the fundamental provisions of SFAS No. 121 and the requirements in APB 30 to report separately discontinued operations. SFAS No. 144 also extends the reporting of discontinued operations to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. The Company adopted SFAS No. 144 on October 1, 2002, and the adoption did not have a material effect on its consolidated financial position, results of operations, or cash flows.

In July 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This statement addresses financial accounting and reporting costs associated with exit or disposal activities. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The effect of adopting SFAS No. 146 is that it may affect the timing of recognizing any future restructuring costs as well as amounts recognized.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, which amends SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement requires prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company will adopt the provisions of SFAS No. 148 in the quarter ending March 31, 2003. Management believes that the adoption of the provision of SFAS No. 148 will not have a material effect on the Company’s consolidated financial statements.

On December 19, 2002, the Company acquired all of the outstanding common stock of Lumos Technologies Inc. (“Lumos”), a privately-held developer of sophisticated technology for managing Layer 1 networks. By integrating their capabilities with existing Netcool applications, the Company will be able to deliver comprehensive Layer 1 network visibility, event correlation, and problem resolution to current and future users of the Netcool suite. Under the terms of the acquisition agreement, the Company will pay up to $2.7 million in cash and has assumed $0.9 million in outstanding debt. Approximately $1.0 million of the cash purchase price was paid at closing, with the remainder payable in connection with certain earnouts in relation to certain revenue, development and employee retention

goals, until the quarter ending December 31, 2003. The transaction was accounted for under the purchase method of accounting with Lumos’ results of operations included from the acquisition date.

A summary of the allocation of the initial purchase price is as follows (in millions):

At the time of the acquisition, the estimated aggregate fair value of Lumos’ research and development efforts that had not reached technological feasibility as of the acquisition date and had no alternative future uses was estimated by the Company’s management to be $0.1 million, and was expensed at the acquisition date. Goodwill, which represents the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired less liabilities assumed, will be tested annually for impairment or whenever events or circumstances occur indicating the goodwill might be impaired. Identifiable intangible assets will be amortized on a straight line basis over a period ranging from six months to two years.

The following summary, unaudited and prepared on a pro forma basis, combines the Company’s consolidated results of operations with Lumos’ results of operations for the quarter ending December 31, 2002 and 2001, as if the combination had occurred at the beginning of the periods presented. The table includes the impact of certain adjustments including the elimination of the charge for acquired in-process research and development, and the additional amortization relating to intangible assets acquired (in thousands, except per share amounts):

As a result of the Company’s change in strategy and its desire to improve its cost structure and profitability, the Company announced and implemented two separate restructuring plans.

The fiscal 2002 restructuring plan, which was announced during the quarter ended September 30, 2002, resulted in a decrease of the Company’s workforce by 85 employees and the elimination of excess facilities. In connection with implementation of the restructuring plan, the Company incurred restructuring charges of $4.2 million in the quarter ended September 30, 2002.

The fiscal 2003 restructuring plan, which was announced during the quarter ended December 31, 2002, resulted in a decrease of the Company’s workforce by 117 employees and total restructuring charges of $3.3 million, relating to severance and employment related charges.

Severance and employment-related charges consist primarily of severance, health benefits, other termination costs and legal expenses as a result of the termination of employees. Severance and employment related charges could be higher than the Company has estimated should there be additional arbitration and legal proceedings. The total severance accrual balance of $2.7 million as of December 31, 2002 is expected to be paid by December 21, 2003.

Facility costs primarily represent closure and downsizing costs related to offices in Europe and North America that were vacated as part of the fiscal 2002 restructuring program. Closure and downsizing costs include payments required under lease contracts, after the properties were abandoned, less any applicable estimated sublease income during the period after abandonment. To determine the lease loss portion of the closure and downsizing costs, certain estimates were made related to the (1) time period over which the relevant building would remain vacant, (2) sublease terms, and (3) sublease rates, including common area charges. The lease loss accrual is an estimate and will be adjusted in the future upon triggering events (such as changes in estimates of time to sublease and actual sublease rates). As of December 31, 2002, the remaining $0.7 million accrual of lease termination costs, net of estimated sublease income, is expected to be paid on various dates through December 2005.

The following table sets forth the restructuring activity for the quarter ended December 31, 2002 (in thousands):

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following information should be read in conjunction with the condensed consolidated historical financial information and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Form 10-K as filed with the Securities and Exchange Commission on December 23, 2002.

The statements contained in this Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, beliefs, hopes, intentions or strategies regarding the future. All forward-looking statements in this Form 10-Q are based upon information available to us as of the date hereof, and we assume no obligation to update any such forward-looking statements. Actual results could differ materially from our current expectations. Factors that could cause or contribute to such differences include, but are not limited to: variation in demand for our software products and services; the level and timing of sales; the extent of product and price competition; introductions or enhancements of products or delays in introductions or enhancements of products; hiring and retention of personnel; changes in the mix of products and services sold; general domestic and international economic and political conditions; and other factors and risks discussed in “Risk Factors” below and elsewhere in this Quarterly Report, and other Micromuse filings with the Securities and Exchange Commission.

Micromuse Inc. develops, markets and supports a family of scalable, highly configurable, rapidly deployable software solutions that enable realtime fault management and service assurance—the effective monitoring and management of multiple elements underlying an Information Technology infrastructure, including network devices, computing systems and applications, and the mapping of these elements to the business services they impact.

Micromuse Ltd (formerly known as Micromuse plc) was incorporated in England in 1989 and in March 1997 became a subsidiary of Micromuse Inc., a Delaware corporation formed in connection with a corporate reorganization and relocation of the corporate headquarters to San Francisco, California. As used herein, the term “Micromuse” or the “Company” refers to Micromuse Inc., Micromuse Ltd, and their other subsidiaries, unless the context otherwise requires or unless otherwise expressly stated. Our principal executive offices are located at 139 Townsend Street, San Francisco, California 94107, and our telephone number at that address is (415) 538-9090.

On December 13, 2002, the Company announced that Gregory Q. Brown would resign as Chairman and Chief Executive Officer but will retain his seat on the Micromuse Board of Directors. On January 1, 2003, Mike Luetkemeyer, Senior Vice President and Chief Financial Officer, assumed the role of CEO on an interim basis. On December 19, 2002, we acquired Lumos Technologies Inc., a developer of sophisticated technology for managing Layer 1 networks headquartered in Santa Monica, California, for cash and assumption of debt, as described in Note 2 of the Condensed Consolidated Financial Statements included in this report.

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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. On an on-going basis, we evaluate our estimates, including, but not limited to, revenue recognition, bad debts, warranty obligations, investments, intangible assets, income taxes, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe 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 are the critical accounting policies and estimates that are used in the preparation of our consolidated financial statements:

Revenue Recognition. Our revenues are derived from license revenues for our Netcool family of products, as well as associated maintenance, consulting and training services revenues. We recognize revenue in accordance with Statement of Position 97-2, Software Revenue Recognition (SOP 97-2), as amended by SOP 98-9, and recognize revenue using the residual method. Under the residual method, revenue is recognized when vendor specific objective evidence of fair value exists for all of the undelivered elements in the arrangement (i.e., maintenance and professional services), but does not exist for one or more of the delivered elements in the arrangement (i.e., the software product). We allocate revenue to each undelivered element based on its respective fair value, with the fair value determined by the price charged when that element is sold separately. We determine the fair value of the maintenance portion of the arrangement to be based on the renewal price charged to the customer when maintenance is sold separately or the option price for annual maintenance renewals included in the underlying customer contracts. The fair value of the professional services portion of the arrangement is based on the hourly rates that we charge for these services when sold independently from a software license. At the outset of the arrangement with the customer, we defer revenue for the fair value of the undelivered elements and recognize revenue for the delivered elements when the basic criteria of SOP 97-2 have been met. If evidence of fair value cannot be established for the undelivered elements of a license agreement, the entire amount of revenue from the arrangement is deferred and recognized over the period that these elements are delivered.

For all of our software arrangements, we defer revenue for the fair value of the undelivered elements and recognize revenue for the delivered elements when the basic criteria of SOP 97-2 have been met—(1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the vendor’s fee is fixed or determinable and (4) collectibility is probable. We evaluate each as follows:

Maintenance revenues from ongoing customer support and product upgrades are deferred and recognized ratably over the term of the maintenance agreement, typically 12 months. Payments for maintenance fees (on initial order or on renewal) are generally made in advance and are nonrefundable. Revenues for professional services are recognized as the services are performed. Professional services generally are not essential to the functionality of the software. Our software products are fully functional upon delivery and do not require any significant modification or alteration.

Deferred revenue includes revenue not yet recognized as a result of deferred maintenance, professional services not yet rendered and license revenue deferred until all the requirements of SOP 97-2 are met.

Allowance for Doubtful Accounts. We regularly review the adequacy of our allowance for doubtful accounts after considering the components of the accounts receivable aging, the age of each invoice, each customer’s expected ability to pay and our collection history with each customer. We review any invoice greater than 30 days past due to determine if an allowance is appropriate based on its risk category. In addition, we maintain a general reserve for all invoices by applying a percentage based on each 30-day aged category. In determining these percentages, we analyze our historical collection experience by region and current economic trends. If the historical data we use to calculate the allowance provided for doubtful accounts does not accurately reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and the future results of operations could be materially affected. However, historically the reserve has proven to be adequate.

Circumstances that have caused revisions to the allowance calculation have been primarily due to the contraction of the overall economy. Continued deterioration in the economy may result in more customers being placed in the specific account reserve category, thereby increasing our reserve estimate and negatively impacting operating results.

Impairment Assessments. We perform an impairment assessment of goodwill and other intangible assets whenever events or changes in circumstances indicate that the carrying value of goodwill and other intangible assets may not be recoverable. Significant changes in circumstances can be both internal to our strategic and financial direction, as well as changes to the competitive and economic landscape. Changes in circumstances that are considered important for asset impairment include, but are not limited to, decrease in our market capitalization, contraction of the telecommunications industry, reduction or elimination of geographic economic growth, reductions in our forecasted growth and significant changes to operating costs.

As part of our impairment assessment, we examine economic conditions, products, customer base and geography. Based on these criteria, we determine which products we will continue to support and sell and, thereby, determine which assets will continue to have future strategic value and benefit. We then

estimate the value of the goodwill based on the sum of the expected future cash flows expected to result from the use of the assets and their eventual disposition.

Restructuring-related Assessments. Our critical accounting policy and judgment as it relates to restructuring-related assessments includes our estimate of facility costs and severance-related costs. To determine the facility costs, which is the loss after the Company’s cost recovery efforts from subleasing a building, certain estimates were made related to the (1) time period over which the relevant building would remain vacant, (2) sublease terms, and (3) sublease rates, including common area charges. The lease loss is an estimate and represents the low end of the range. We have estimated that if we were unable to find a suitable tenant to sublease the facilities until expiration of the leases, we would incur a maximum additional amount of approximately $1.0 million. To determine the severance and employment-related charges, we have made certain estimates as they relate to severance benefits including the remaining time employees will be retained, the estimated severance period, health benefits and other termination costs as well as the estimated legal costs. Severance and employment-related charges for the fiscal 2003 restructuring plan could be higher than we have estimated should there be additional arbitration and legal proceedings.

We prepare and release quarterly unaudited financial statements prepared in accordance with generally accepted accounting principles (“GAAP”). We also disclose and discuss certain pro forma financial information in the related earnings release and investor conference call. This pro forma financial information excludes certain non-cash and special charges, consisting primarily of the amortization and impairment of goodwill and other intangible assets, restructuring costs and executive recruiting costs. We believe the disclosure of the pro forma financial information helps investors more meaningfully evaluate the results of our ongoing operations. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K, and our quarterly earnings releases.

The following table sets forth certain items in our consolidated statement of operations as a percentage of total revenues, except as indicated:

Revenues. Revenues decreased to $27.1 million in the quarter ended December 31, 2002, from $40.0 million in the comparable period of the prior year. License revenues decreased to $13.4 million in the quarter ended December 31, 2002, from $23.2 million in the comparable period of the prior year. The decline in license revenues was primarily due to the current economic slowdown that is limiting the overall capital spending of our existing and potential customers. Maintenance and services revenues decreased to $13.7 million in the quarter ended December 31, 2002, from $16.8 million in the comparable period of the prior year. The decrease in maintenance and services revenues was a result of the related decrease in license revenue and lower overall services revenue. License revenues as a percentage of total revenues was 49.5% and in the quarter ended December 31, 2002, as compared to 58.0% in the comparable period of the prior year.

Cost of Revenues. The cost of license revenues consists primarily of technology license fees paid to third-party software vendors and production costs. Cost of license revenues as a percentage of license revenues increased to 8.0% in the quarter ended December 31, 2002, as compared to 6.9% in the comparable period of the prior year. The increase was mainly due to a change in the mix of license revenue in the current quarter. The cost of maintenance and services revenues consists primarily of personnel-related costs incurred in providing maintenance, consulting and training to customers. Cost of maintenance and services revenues as a percentage of maintenance and services revenues decreased to 24.1% in the quarter ended December 31, 2002, from 30.9% in the comparable period of the prior year. This improvement was principally due to a proportionally greater percentage of higher-margin maintenance revenues over services revenue, economies of scale, and the decrease in headcount, facilities, and travel costs.

Sales and Marketing Expenses. Sales and marketing expenses decreased to $14.4 million in the quarter ended December 31, 2002, from $18.1 million in the comparable period of the prior year. This decrease was primarily due to the decrease in sales commission as a result of the related decrease in revenue and a decrease in personnel related costs as a result of lower headcount and travel expenditures. Sales and marketing expenses as a percentage of total revenues increased to 53.3% in the quarter ended December 31, 2002, from 45.1% in the comparable period of the prior year.

Research and Development Expenses. Research and development expenses decreased to $7.4 million in the quarter ended December 31, 2002, from $7.6 million in the comparable period of the prior year. The decrease was primarily due to the decrease in headcount and travel related expenditures. Research and development costs as a percentage of total revenues have increased to 27.4% in the quarter ended December 31, 2002, as compared to 18.9% in the same period of the prior year.

General and Administrative Expenses. General and administrative expenses decreased to $4.1 million in the quarter ended December 31, 2002, from $4.9 million in the comparable period of the prior year. The decrease in general and administrative expenses was primarily due to lower bad debt expense and a decrease in headcount, which were partially offset by an increase in professional fees. General and administrative expenses as a percentage of revenues have increased to 15.0% in the quarter ended December 31, 2002, from 12.3% in the comparable period of the prior year.

Amortization of Goodwill and Other Intangible Assets. The charge of $1.6 million and $2.8 million in the quarter ended December 31, 2002 and 2001, respectively, reflects the amortization of the goodwill and other intangible assets over estimated useful lives of three to five years. The decrease was mainly due to the adoption of SFAS No. 142, which changed the accounting for goodwill from an amortization method to an impairment-only approach.

Purchased In-Process Research and Development. For each of our acquisitions, we allocated part of the purchase price to developed technology and in-process research and development (IPR&D). This allocation was based on whether or not technological feasibility had been achieved and whether there was an alternative future use for the technology. Statement of Financial Accounting Standards (SFAS) No. 86, Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed, sets guidelines for establishing technological feasibility. Technological feasibility is determined when a product reaches the “working model” stage, which is generally when a product is classified as a beta version release. For the acquisition of Lumos Technologies Inc. in December 2002, we concluded that the purchased IPR&D of $0.1 million had not yet reached technological feasibility and had no alternative use. Therefore, we expensed these costs at the time of the purchase, according to the provisions of FASB Interpretation No. 4, Applicability of SFAS No. 2 to Business Combinations Accounted for by the Purchase Method.

Restructuring Costs. During the quarter ended December 31, 2002, we incurred $3.3 million in restructuring costs. (See “Restructuring-related Assessment” under Critical Accounting Policies and also Note 3 of Notes to Condensed Consolidated Financial Statements.)

Executive Recruiting Costs. The executive recruiting costs of $0.4 million in the quarter ended December 31, 2001 are primarily costs incurred in the recruitment of a new Chief Financial Officer. The costs relate to the fair value of a warrant issued to an executive recruiting firm, fees paid to the recruiting firm and certain relocation costs.

Other Income, Net. Other income decreased to $1.4 million in the quarter ended December 31, 2002, from $1.6 million in the comparable period of the prior year. This net decrease was primarily due to the decline in interest rates over the past year.

Provision for Income Taxes. Income taxes showed a charge of $0.5 million in the quarter ended December 31, 2002, as compared to $0.4 million in the comparable periods of the prior year. Although we had a loss before income tax, we had a tax expense as we had income in certain tax jurisdictions, which could not be offset against losses in other tax jurisdictions.

As of December 31, 2002, we had $135.5 million in cash and cash equivalents and $65.3 million in marketable securities, as compared to $117.2 million in cash and cash equivalents and $70.4 million in marketable securities as of September 30, 2002. The net increase in cash and cash equivalents in the quarter ended December 31, 2002, was due primarily to net loss adjusted for non-cash expenses, the decrease in billed receivables and prepaid expenses and other current assets, the increase in accounts payable and accrued expenses, the increase in deferred revenue, the net proceeds from the maturity of investments and the proceeds from the issuance of common stock. These sources of cash and cash equivalents were partially offset by capital expenditures and the acquisition of Lumos Technologies Inc.

As of December 31, 2002, the Company’s principal commitments consisted of obligations under operating leases.

We believe that our current cash balances and the cash flows generated by operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the next 12 months. Thereafter, if cash generated from operations is insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or convertible debt securities or obtain credit facilities. The decision

to sell additional equity or debt securities could be made at any time and would likely result in additional dilution to our stockholders. A portion of our cash may be used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, we evaluate potential acquisitions of such businesses, products or technologies.

The following factors, in addition to the other information contained in this report, should be considered carefully in evaluating the Company and our prospects. This report (including without limitation the following Risk Factors) 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) regarding the Company and our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements.

Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors we currently know about. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, but are not limited to, those discussed below and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as those discussed elsewhere in this report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of the report.

Our operating results may vary as a result of the current economic slowdown.

We face uncertainty in the degree to which the current economic slowdown will negatively affect growth and capital spending by our existing and potential customers. We continue to experience increased instances of customers delaying or deferring licenses of our software and maintenance agreement, and longer lead times needed to close our customer sales. In addition, recent political turmoil in many parts of the world, including terrorist and military actions, may continue to put pressure on global economic conditions. If the economic conditions in the United States and globally do not improve, or if we experience a worsening in the global economic slowdown, we may continue to experience material adverse impacts on our business, operating results, and financial condition. We may not be able to accurately anticipate the magnitude of these impacts on future quarterly and annual results.

Our operating results may vary from quarter to quarter, causing our stock price to fluctuate.

Our operating results have in the past, and will continue to be, subject to quarterly and annual fluctuations. Our quarterly revenues and operating results in geographic segments that we track fluctuate and are difficult to predict. It is possible that in some quarter or quarters our operating results will be below the expectations of public market analysts or investors. In such event, or in the event

adverse conditions prevail, or are perceived to prevail, with respect to our business or financial markets generally, the market price of our common stock may decline significantly.

We realize a significant portion of our license revenues in the last month of a quarter, frequently in the last weeks or even days of a quarter. As a result, license revenues in any quarter are difficult to forecast because it is substantially dependent on orders booked and shipped in that quarter. Moreover, our sales cycle, from initial evaluation to delivery of software, varies substantially from customer to customer. Further, we base our expense levels in part on forecasts of future orders and sales, which are extremely difficult to predict. A substantial portion of our operating expenses is related to personnel, facilities, and sales and marketing programs. The level of spending for such expenses cannot be adjusted quickly and is, therefore, relatively fixed in the short term. Accordingly, our operating results will be harmed if revenues fall below our expectations in a particular quarter. In addition, the number and timing of large individual sales has been difficult for us to predict, and large individual sales have, in some cases, occurred in quarters subsequent to those we anticipated, or have not occurred at all. The loss or deferral of one or more significant sales in a quarter could harm our operating results.

Because of these fluctuations we believe that quarter-to-quarter comparisons of our operating results are not necessarily meaningful or indicative of our future performance. A number of other factors are likely to cause these variations, including:

Therefore, operating results for a particular future period are difficult to predict and prior results are not necessarily indicative of results to be expected in future periods. Any of the foregoing factors, or others discussed elsewhere herein, could have a material adverse effect on our business, operating results, financial condition and stock price.

Over the past few years, we have added customers, personnel and expanded the scope and geographic area of our operations that has placed and will continue to place a significant strain upon our management and our operating and financial systems and resources. However, we have reduced our headcount from 660 employees on September 30, 2002 to 550 employees on December 31, 2002, mainly as a result of planned reductions and attrition. Given the uncertainties discussed in this Risk Factors section, together with factors that might affect our ability to quickly expand or contract our work force around the world, it is difficult to predict future requirements for the number and type of employees in the fields and geographies in which we operate. Failure to align employee skills and populations with revenue and market requirements would have a material adverse impact on our business and its operating results.

Our restructuring of operations may not achieve the results we intend and may harm our business.

In the quarters ended September 30, 2002 and December 31, 2002, we initiated plans to streamline operations and reduce expenses, which included cuts in discretionary spending, reductions in capital expenditures, reductions in the work force and consolidation of certain office locations, as well as other steps to reduce expenses. The implementation of our restructuring plans has placed, and may continue to place, a significant strain on our managerial, operational, financial, employee and other resources. Additionally, the restructurings may negatively affect our employee turnover as well as recruiting and retention of important employees. It is possible that these reductions could impair our marketing, sales and customer support efforts or alter our product development plans. If we experience difficulties in carrying out the restructuring plans, our expenses could increase more quickly than we expect. If we find that our planned restructurings do not achieve our objectives, it may be necessary to implement further reduction of our expenses, to perform additional reductions in our headcount, or to undertake additional restructurings of our business.

To succeed in the implementation of our business strategy, we must execute our sales strategy and further develop products and expand service capabilities, while managing future operations by

implementing effective planning and operating processes. If we fail to manage effectively, our business could suffer. To manage, we must:

We need to continue to expand our distribution channels and retain our existing third-party distributors.

We need to continue to develop relationships with leading network equipment and telecommunications providers and to expand our third-party channels of distribution through OEMs, resellers and systems integrators. We currently invest significant resources to develop these relationships and channels of distribution, which could reduce our ability to generate profits. Third-party distributors accounted for approximately 38%, 48% and 42% of our total revenues in the three months ended December 31, 2002, fiscal 2002 and fiscal 2001, respectively. Our business will be harmed if we are not able to retain and attract additional distributors that market our products effectively. Further, many of our agreements with third-party distributors are nonexclusive, and many of the companies with which we have agreements also have similar agreements with our competitors or potential competitors. Our third-party distributors have significantly greater sales and marketing resources than we do, and their sales and marketing efforts may conflict with our direct sales efforts. In addition, although sales through third-party distributors result in reduced sales and marketing expense with respect to such sales, we sell our products to third-party distributors at reduced prices, resulting in lower gross margins on such third-party sales. We believe that our success in penetrating markets for our fault and service level management applications depends substantially on our ability to maintain our current distribution relationships, in particular, those with Cisco Systems, IBM, Ericsson, Unisphere (Siemens), Sun Microsystems and others. Our business will be harmed if network equipment and telecommunications providers and distributors discontinue their relationships with us, compete directly with us or form additional competing arrangements with our competitors.

We are dependent on the market for software designed for use with advanced communications services, and the size of this market is unproven.

The market for our products is in an early stage of development or is developed but not highly penetrated. Although the rapid expansion and increasing complexity of computer networks in recent years and the resulting emergence of service level agreements has increased, the demand for fault and service level management software products, the awareness of and the need for such products is a recent development. Therefore, it is difficult to assess the size of this market, the appropriate features and prices for products to address this market, the optimal distribution strategy and the competitive environment that will develop.

We are substantially dependent upon telecommunications carriers and other service providers continuing to purchase our products.

Telecommunications carriers, including Internet service providers, that deliver advanced communications services to their customers accounted for approximately 71%, 74% and 79% of our total revenues in the three months ended December 31, 2002, fiscal 2002 and fiscal 2001, respectively. In addition, these providers are an important focus of our sales strategy. If these customers cease to deploy advanced communications services for any reason, the market for our products will be harmed. Also, delays in the introduction of advanced services or the failure of such services to gain widespread market acceptance or the decision of telecommunications carriers and other service providers not to use our products in the deployment of these services would harm our business.

Consolidations in, or a continued slowdown in, the telecommunications industry could harm our business.

We have derived a substantial amount of our revenues from sales of products and related services to the telecommunications industry. The telecommunications industry has experienced significant growth and consolidation in the past few years, although over the recent year trends indicate that capital spending by this industry has decreased and may continue to decrease in the future as a result of a general decline in economic growth in local and international markets. Our business is highly dependent on the telecommunications industry and on continued capital spending by our customers in that industry. In the event of further significant slowdown in capital spending of the telecommunications industry, our business would be adversely affected. Furthermore, as a result of industry consolidation, there may be fewer potential customers requiring our software in the future. Larger, consolidated telecommunications companies may also use their purchasing power to create pressure on the prices and the margins we could realize. We cannot be certain that consolidations in, or a slowdown in the growth of, the telecommunication industry will not harm our business.

Our business depends on the continued growth in use and improvement of the Internet.

A significant portion of our revenues comes from telecommunications carriers, Internet service providers and other customers that rely upon or are driven by the Internet. As a result, our future results of operations substantially depend on the continued acceptance and use of the Internet as a medium for commerce and communication. Our business could be harmed if this growth does not continue or if the rate of technological innovation, deployment or use of the Internet slows or declines. Recent data and reports indicate that both the growth of significant portions of the Internet and technological innovations have slowed. If these trends continue, they will likely have an adverse impact on our business.

Furthermore, the growth and development of the market for Internet-based services may prompt the introduction of new laws and regulations. Laws, which impose additional burdens on those companies that conduct business online, could decrease the expansion of the use of the Internet. A decline in the growth of the Internet could decrease demand for our products and services and increase our cost of doing business, or otherwise harm our business, which could result in a material adverse effect on the market price of our common stock.

We face intense competition, including from larger competitors with greater resources than our own, which could result in our losing market share or experiencing a decline in gross margins.

We face intense competition in our markets. As we enter new markets, we encounter additional, market-specific competitors. In addition, because the software market has relatively low barriers to entry, we are aware of new and potential entrants in portions of our market space. Increased competition is likely to result in price reductions and may result in reduced gross margins and loss of market share.

Further, many of our competitors have longer operating histories and have significantly greater financial, technical, sales, marketing and other resources, as well as greater name recognition and a larger customer base, than we do. As a result, they may be able to devote greater resources to the development, promotion, sale and support of their products or to respond more quickly to new or emerging technologies and changes in customer requirements than we can. Existing competitors could also increase their market share by bundling products having functionality offered by our products with their current applications. Moreover, our current and potential competitors may increase their share of the fault and service level management market by strategic alliances and/or the acquisition of competing companies. In addition, network operating system vendors could introduce new or upgrade and extend existing operating systems or environments that include functionality offered by our products, which could render our products obsolete and unmarketable.

Our current and prospective competitors offer a variety of solutions to address the fault and service level and enterprise network management markets and generally fall within the following five categories:

Many of our existing and potential customers and distributors continuously evaluate whether to design and develop their own network operations support and management applications or purchase them from outside vendors. Sometimes these customers internally design and develop their own software solutions for their particular needs and therefore may be reluctant to purchase products offered by independent vendors such as ours. As a result, we must continuously educate existing and prospective customers as to the advantages of our products versus internally developed network operations support and management applications.

If we ship products that contain defects, the market acceptance of our products and our reputation will be harmed, and our customers could seek to recover their damages from us.

Complex software products frequently contain errors or defects, especially when first introduced or when new versions or enhancements are released. Because of defects, we could continue to experience delays in or failure of market acceptance of products, or damage to our reputation or relationships with our customers. Any defects and errors in new versions or enhancements of our products after commencement of commercial shipments would harm our business.

In addition, because our products are used to monitor and address network problems and avoid failures of the network to support critical business functions, any design defects, software errors, misuse of our products, incorrect data from network elements or other potential problems within or out of our control that may arise from the use of our products could result in financial or other damages to our customers. Our customers could seek to have us pay for these losses. Although we maintain product liability insurance, it may not be adequate. Further, although our license agreements with our customers typically contain provisions designed to limit our exposure to potential claims as well as any liabilities arising from such claims, such provisions may not effectively protect us against such claims and the liability and costs associated therewith.

The sales cycle for our software products is long, and the delay or failure to complete one or more large license transactions in a quarter could cause our operating results to fall below our expectations.

The sales cycle is highly customer specific and can vary from a few weeks to many months. The software requirements of customers is highly dependent on many factors, including but not limited to their projections of business growth, capital budgets and anticipated cost savings from implementation of our software. Our delay or failure to complete one or more large license transactions in a quarter could harm our operating results. Our software is generally used for division-wide or enterprise-wide, business-critical purposes and involves significant capital commitments by customers. Potential customers generally commit significant resources to an evaluation of available enterprise software and requires us to expend substantial time, effort and money educating them about the value of our solutions. Licensing of our software products often requires an extensive sales effort throughout a customer’s organization because decisions to license such software generally involve the evaluation of the software by a significant number of customer personnel in various functional and geographic areas, each often having specific and conflicting requirements. A variety of factors, including actions by competitors and other factors over which we have little or no control, may cause potential customers to favor a particular supplier or to delay or forego a purchase.

We depend on our key personnel, and the loss of any of our key personnel could harm our business.

On December 13, 2002, we announced that Gregory Q. Brown is resigning as Chairman and Chief Executive Officer, to assume a position as Executive Vice President of Motorola, Inc. and President and CEO of Motorola’s Communications, Government and Industrial Solutions Sector. Michael L. Luetkemeyer, Senior Vice President and Chief Financial Officer, has been appointed Chief Executive Officer of Micromuse on an interim basis effective January 1, 2003, and will retain his responsibilities as Chief Financial Officer. Our Board of Directors is currently undertaking a search for the Chief Executive Officer position, and have stated in our public conference call on December 13, 2002, that Mr. Luetkemeyer is expected to be a potential candidate for that position.

On September 30, 2002, Katrinka McCallum resigned her position as Chief Operating Officer. We do not currently intend to appoint an individual to fill that position.

Our success is substantially dependent upon a limited number of key management, sales, product development, technical services and customer support personnel. The loss of the services of one or more of such key employees could harm our business. We do not generally have employment contracts with key personnel. In addition, we are dependent upon our continuing ability to attract, train and retain additional highly qualified management, sales, product development, technical services and customer support personnel. We have at times experienced and continue to experience difficulty in recruiting qualified personnel. Also, the volatility or lack of positive performance in our stock price may also adversely affect our ability to attract and retain key employees, who often expect to realize value from stock options. Because we face intense competition in our recruiting activities, we may be unable to attract and/or retain qualified personnel.

Mr. Brown’s resignation creates uncertainties attendant to the search process for a non-interim Chief Executive Officer, including the length of time that may be needed for that purpose, whether our Board of Directors will ultimately select our interim Chief Executive Officer or another candidate for that position, our ability to attract and employ on acceptable terms an individual who will successfully follow Mr. Brown, and the ability of our continuing management team and ultimate Chief Executive Officer to maintain continuity with our existing customers, manage our employees, and execute our ongoing and future business strategies.

We have acquired other businesses and we may make additional acquisitions in the future, which will complicate our management tasks and could result in substantial expenditures.

We have acquired other businesses and we may make additional acquisitions in the future, which will complicate our management tasks and could result in substantial expenditures. In August 2002, we completed the acquisition of RiverSoft plc, a developer of flexible object modeling and root-cause analysis software. In December 2002, we completed the acquisition of Lumos Technologies Inc., a developer of sophisticated technology for managing Layer 1 networks. Because of these acquisitions, we are integrating distinct products, customers and corporate cultures into our own. These past and potential future acquisitions create numerous risks for us, including:

Further, some of the products we acquire would require significant additional development before they can be marketed and may not generate revenue at levels we anticipate. Moreover, our future

acquisitions, if any, may result in issuances of our equity securities which dilute our stockholders, the incurrence of debt, large one-time write-offs and creation of goodwill or other intangible assets that could result in amortization and impairment expense. It is possible that our efforts to consummate or integrate acquisitions will not be successful, which would harm our business.

We have relied and expect to continue to rely on a limited number of products for a significant portion of our revenues.

All of our revenues have been derived from licenses for our Netcool family of products and related maintenance, training and consulting services. We currently expect that Netcool/OMNIbus-related revenues will continue to account for a substantial percentage of our revenues beyond fiscal 2002 and for the foreseeable future thereafter. Although we have Netcool/OMNIbus for Voice Networks, Netcool/Precision, Netcool/Visionary and other products, our future operating results, particularly in the near term, are significantly dependent upon the continued market acceptance of Netcool/OMNIbus, improvements to Netcool/OMNIbus and new and enhanced Netcool/OMNIbus applications. Our business will be harmed if Netcool/OMNIbus does not continue to achieve market acceptance or if we fail to develop and market improvements to Netcool/OMNIbus or new or enhanced products. The life cycles of Netcool/OMNIbus, including the Netcool/OMNIbus applications, are difficult to estimate due in large part to the recent emergence of many of our markets, the effect of future product enhancements and competition. A decline in the demand for Netcool/OMNIbus as a result of competition, technological change or other factors would harm our business.

We have relied and expect to continue to rely on a limited number of customers for a significant portion of our revenues.

We derive a significant portion of our revenues in any particular period from a limited number of customers. See “Concentration of Revenues” in Notes to Condensed Consolidated Financial Statements. We expect to derive a significant portion of our revenues from a limited number of customers in the future. If a significant customer, or group of customers, cancels or delays orders for our products, or does not continue to purchase our products at or above historical levels, our business will be harmed. For example, pre-existing customers may be part of, or become part of, large organizations that standardize using a competitive product. The terms of our agreements with our customers typically contain a one-time license fee and a prepayment of one year of maintenance fees. The maintenance agreement is renewable annually at the option of the customer and there are no minimum payment obligations or obligations to license additional software. Therefore, we generally do not have long-term customer contracts upon which we can rely for future revenues.

Our business is subject to risks from global operations and we are exposed to fluctuations in currency exchange rates.

We license our products in foreign countries. In addition, we maintain a significant portion of our operations, including the bulk of our software development operations, in the United Kingdom. Fluctuations in the value of these currencies relative to the United States dollar have adversely impacted our results in the past and may do so in the future. See “Geographic and Segment Information” in Notes to Condensed Consolidated Financial Statements for information concerning revenues outside the United States. We expect that international license, maintenance and consulting revenues will continue to account for a significant portion of our total revenues in the future. We pay the expenses of our international operations in local currencies and do not currently engage in hedging transactions with respect to such obligations.

Our international operations and revenues involve a number of other inherent risks, including:

We intend to enter into additional international markets and to continue to expand our operations outside of the United States. Such expansion will require significant management attention and expenditure of significant financial resources and could adversely affect our ability to generate profits. If we are unable to establish additional foreign operations in a timely manner, our growth in international sales will be limited, and our business could be harmed.

Rapid technological change, including evolving industry standards and regulations and new product introductions by our competitors, could render our products obsolete.

Rapid technological change, including evolving industry standards and regulations and new product introductions by our competitors, could render our products obsolete. As a result, the life cycles of our products are difficult to estimate and we must constantly develop, market and sell new and enhanced products. If we fail to do so, our business will be harmed. For example, the widespread adoption of new architecture standards for managing telecommunications networks would force us to adapt our products to such standard, which we may be unable to do on a timely basis or at all. In addition, to the extent that any product upgrade or enhancement requires extensive installation and configuration, current customers may postpone or forgo the purchase of new versions of our products. Further, the introduction or announcement of new product offerings by us or one or more of our competitors may cause our customers to defer licensing of our existing products.

Our products operate on third-party software platforms, and we could lose market share if our products do not operate on the hardware and software operating platforms employed by our customers.

Our products operate on third-party software platforms and we could lose market share if our products do not operate on the hardware and software operating platforms employed by our customers. Our products are designed to operate on a variety of hardware and software platforms employed by our customers in their networks. We must continually modify and enhance our products to keep pace with changes in hardware and software platforms and database technology. As a result, uncertainties related to the timing and nature of new product announcements, introductions or modifications by systems vendors, particularly Sun Microsystems, Inc., International Business Machines Corporation, Hewlett-Packard Company, and Cisco Systems, Inc. and by vendors of relational database software, particularly Oracle Corporation and Sybase, Inc., could harm our business.

Our efforts to protect our intellectual property may not be adequate, and a third-party has made claims that we are infringing its proprietary rights.

We cannot guarantee that the steps we have taken to protect our proprietary rights will be adequate to deter misappropriation of our intellectual property. In addition, we may not be able to detect unauthorized use of our intellectual property and take appropriate steps to enforce our rights. If third parties infringe or misappropriate our trade secrets, copyrights, patents, trademarks or other proprietary information or intellectual property, our business could be harmed. In addition, protection of intellectual property in many foreign countries is weaker and less reliable than in the United States, so as our international operations expand, the risk that we will fail to adequately protect our intellectual property increases.

While we believe that our products and trademarks do not infringe upon the proprietary rights of third parties, other parties may assert that our products infringe, or may infringe, their proprietary rights or that we have not fulfilled the terms of agreements with them. On December 9, 2002, Aprisma Management Technologies, Inc. filed a complaint against Micromuse in the U.S. District Court for the District of New Hampshire. See Part II, Item 1, Legal Proceedings, for additional information relating to this matter.

Any litigation, whether against us or brought by us, may be time consuming and could result in substantial costs and diversion of our human resources. The Aprisma matter is in a preliminary stage and we cannot predict its outcome with certainty. Management believes that Micromuse has strong defenses to Aprisma’s claims including non-infringement of the patents by Micromuse’s products and invalidity of Aprisma’s patents. However, management is aware that the litigation process is inherently uncertain on any individual claims. Additionally, litigation involving intellectual property, such as the Aprisma matter, can become complex and extend for a protracted time, which may increase the cost of such litigation. Protracted litigation may also divert the efforts and attention of some of our key management and technical personnel. Should the outcome of this litigation be adverse to us, we may be required to pay monetary damages to Aprisma, and we could be enjoined from selling any of our products found to infringe Aprisma’s patents without a license from Aprisma, which may not be available on acceptable terms or at all. If we are required to pay significant monetary damages, are enjoined from selling any of our products or are required to make substantial royalty payments, our business would be harmed.

We rely on software that we have licensed from third-party developers to perform key functions in our products.

We rely on software that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. We could lose the right to use this software or it could be made available to us only on commercially unreasonable terms. Although we believe that alternative software is available from other third-party suppliers or internal developments, the loss of or inability to maintain any of these software licenses or the inability of the third parties to enhance in a timely and cost-effective manner their products in response to changing customer needs, industry standards or technological developments could result in delays or reductions in product shipments by us until equivalent software could be developed internally or identified, licensed and integrated, which would harm our business.

Our stock price is volatile, exposing us to possible risks of costly and time-consuming securities class action litigation.

The market price of our common stock has been and is likely to continue to be highly volatile. The market price may vary in response to many factors, some of which are outside our control, including:

In addition, the stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market price for the common stock of technology companies. These types of broad market fluctuations may adversely affect the market price of our common stock. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been initiated against such company. Such litigation could result in substantial costs and a diversion of our management’s attention and resources that could harm our business.

Due to rapidly changing market conditions, our goodwill and other intangible assets may become impaired such that their carrying amounts may not be recoverable, and we may be required to record an impairment charge impacting our financial position. As of December 31, 2002, we had approximately $41.4 million of goodwill and other intangible assets, which relate to the acquisitions of CAN, NetOps, RiverSoft and Lumos. We regularly perform reviews to determine if the carrying value of assets is impaired. As part of our impairment assessment, we examine economic conditions, products, customer base and geography. Based on these criteria, we determine which products we will continue to support and sell and, thereby, determine which assets will continue to have future strategic value and benefit.

No such impairment has been indicated to date. Asset impairment charges of this nature could be large and could have a material adverse effect on our financial condition and reported results of operations. In the quarter ended March 31, 2003, the Company will perform its transitional goodwill impairment test required under SFAS No. 142.

Future sales of our common stock may affect the market price of our common stock.

As of December 31, 2002, we had approximately 75.3 million shares of common stock outstanding, excluding approximately 15.2 million shares subject to options outstanding as of such date under our stock option plans that are exercisable at prices ranging from approximately $0.58 to $106.22 per share. We cannot predict the effect, if any, that future sales of common stock or the availability of shares of common stock for future sale, will have on the market price of common stock prevailing from time to time. Sales of substantial amounts of common stock (including shares issued upon the exercise of stock options), or the perception such sales could occur, may materially and adversely affect prevailing market prices for common stock. In addition, tax charges resulting from the exercise of stock options could adversely affect the reported results of operations.

Certain provisions of our certificate of incorporation and bylaws and certain provisions of Delaware law could delay or make difficult a change in control of Micromuse that a stockholder may consider favorable. The provisions include:

In addition, Section 203 of the General Corporation Law of the State of Delaware, which is applicable to us, and our stock incentive plans, may discourage, delay or prevent a change of control of Micromuse.

Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates, changes in the valuation of our deferred tax assets and liabilities, or by changes in tax laws or interpretations thereof.

Our business is especially subject to the risks of earthquakes, floods and other natural catastrophic events, and to interruption by man-made problems such as computer viruses or terrorism.

Our corporate headquarters are located in San Francisco, a region known for seismic activity. A significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on our business, operating results and financial condition. In addition, our servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems. Any such event could have a material adverse effect on our business, operating results and financial condition. In addition, the effects of war or acts of terrorism could have a material adverse effect on our business, operating results and financial condition. The terrorist attacks in New York and Washington, D.C. on September 11, 2001 disrupted commerce throughout the world and intensified the

uncertainty of the U.S. and other economies. The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to these economies and create further uncertainties. To the extent that such disruptions or uncertainties result in delays or cancellations of customer orders, or the manufacture or shipment of our products, our business, operating results and financial condition could be materially and adversely affected.

We transact business in various foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to local currency denominated revenues and operating expenses in the U.K. However, as of December 31, 2002, no hedging contracts were outstanding.

We have entered into foreign exchange forward contracts to reduce our exposure to foreign currency rate changes on receivables, payables and intercompany balances denominated in a nonfunctional currency. The objective of these contracts is to neutralize the impact of foreign currency exchange rate movements on our operating results. These contracts require us to exchange currencies at rates agreed upon at the inception of the contracts. These contracts reduce the exposure to fluctuations in exchange rate movements because the gains and losses associated with foreign currency balances and transactions are generally offset with the gains and losses of the foreign exchange forward contracts. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the underlying items being hedged, these financial instruments help alleviate the risk that might otherwise result from changes in currency exchange rates. We do not designate our foreign exchange forward contracts as accounting hedges and, accordingly, we adjust these instruments to fair value through earnings in the period of change in their fair value.

The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. Our exposure to market risks for changes in interest rates relate primarily to investments in debt securities issued by U.S. government agencies and corporate debt securities. We place our investments with high credit quality issuers and, by policy, limit the amount of the credit exposure to any one issuer.

Our general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All investments with three months or less to maturity at the date of purchase are considered to be cash equivalents; investments with maturities at the date of purchase between three and twelve months are considered to be short-term investments; investments with maturities in excess of twelve months are considered to be long-term investments. The weighted average pre-tax interest rate on the investment portfolio is approximately 3.1%.

Michael L. Luetkemeyer, currently serving as our interim Chief Executive Officer and as our Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” as defined in Rule 13a-14(c) of the Securities Exchange Act of 1934 (the “Exchange Act”) as of a date within 90 days before the date of filing this report, has concluded that, as of that date, our disclosure controls and procedures are effective to ensure that information required to be disclosed by our company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There were no significant changes in our internal controls or in other factors that could significantly affect our disclosure controls and procedures subsequent to the evaluation date.

On December 9, 2002, Aprisma Management Technologies, Inc. filed a complaint against Micromuse Inc. in the U.S. District Court for the District of New Hampshire. This complaint alleges that our network and systems management products, including our Netcool products, infringe six patents held by Aprisma. The complaint seeks preliminary and permanent injunctive relief as well as unspecified compensatory and enhanced damages, attorneys fees, interest, costs and expenses. Aprisma has not yet served us with this complaint. Micromuse has received preliminary advice from its patent counsel of the availability of a variety of defenses to Aprisma’s claims, including invalidity of the patents, non-infringement of the patents by Micromuse’s products and other equitable defenses. We will vigorously defend our position in the appropriate venue if Aprisma proceeds with this action. Given that litigation matters are inherently unpredictable and this matter is at a preliminary stage, we cannot predict the outcome of this matter with certainty. See “Risk Factor entitled “Our efforts to protect our intellectual property may not be adequate, and a third-party has made claims that we are infringing its proprietary rights.”

The Company’s Annual Meeting of Shareholders was held on January 31, 2003 in San Francisco, California. Of the 74,873,299 shares outstanding as of the record date, 66,877,010 shares were present or represented by proxy at the meeting. The following matters were submitted to a vote of security holders:

(2) To ratify the Company’s appointment of KPMG LLP as independent accountants for the Company for the fiscal year ending September 30, 2003.

A current report on Form 8-K was filed with the Securities and Exchange Commission by Micromuse Inc. on December 2, 2002, to report our agreement to acquire Lumos Technologies Inc.

A current report on Form 8-K was filed with the Securities and Exchange Commission by Micromuse Inc. on December 13, 2002, to announce the following: (i) the resignation of Greg Brown as the Chairman and Chief Executive Officer and his acceptance of a senior executive officer position at Motorola Inc., and that Mike Luetkemeyer will retain his CFO responsibilities and assume role of Micromuse CEO on the interim basis starting January 1, 2003, (ii) David Schwab’s appointment as Chairman effective January 1, 2003, and (iii) the Company expects to meet or exceed current First Call consensus estimates for revenue and pro forma earnings per share in the quarter ending December 31, 2002.

A current report on Form 8-K was filed with the Securities and Exchange Commission by Micromuse Inc. on January 2, 2003, to report the completed acquisition of Lumos Technologies Inc., effective December 19, 2002.

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, on February 12, 2003.

MICROMUSE INC. (Registrant)

By:		/s/ MICHAEL L. LUETKEMEYER
		Michael L. Luetkemeyer Interim Chief Executive Officer and Chief Financial Officer (Principal Financial Officer)

By:

/s/ MICHAEL L. LUETKEMEYER

Michael L. Luetkemeyer

Interim Chief Executive Officer and Chief Financial Officer

DELAWARE		94-3288385
(State or other jurisdiction of		(IRS Employer
incorporation or organization)		Identification No.)

		Page
PART I—Financial Information

Item 1.	Condensed Consolidated Financial Statements:

	Condensed Consolidated Balance Sheets as of December 31, 2002 and September 30, 2002	3

	Condensed Consolidated Statements of Operations for the three months ended December 31, 2002 and 2001	4

	Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2002 and 2001	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	32

Item 4.	Controls and Procedures	33

PART II—Other Information

Item 1.	Legal Proceedings	34

Item 2.	Changes in Securities and Use of Proceeds	34

Item 3.	Defaults upon Senior Securities	34

Item 4.	Submission of Matters to a Vote of Security Holders	34

Item 5.	Other Information	34

Item 6.	Exhibits and Reports on Form 8-K	35

Signature		36

Certifications		37

	December 31, 2002			September 30, 2002
ASSETS
Current assets:
Cash and cash equivalents	$	135,470		$	117,218
Short-term investments		37,031			42,126
Billed receivables, net		12,755			18,386
Prepaid expenses and other current assets		5,663			5,760

Total current assets		190,919			183,490
Property and equipment, net		8,245			9,534
Long-term investments		28,236			28,293
Goodwill and other intangible assets, net		41,369			40,666

	$	268,769		$	261,983

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,853		$	2,374
Accrued expenses		26,086			25,205
Income taxes payable		6,723			6,652
Deferred revenue		49,515			36,524

Total current liabilities		85,177			70,755
Stockholders’ equity
Preferred stock; $0.01 par value; 5,000 shares authorized no shares issued and outstanding		—			—
Common stock; $0.01 par value; 200,000 shares authorized; 75,279 and 75,194 shares outstanding as of December 31, 2002 and September 30, 2002, respectively		753			752
Additional paid-in capital		196,459			196,048
Treasury stock		(2,657	)		(2,657	)
Accumulated comprehensive loss		(1,622	)		(899	)
Accumulated deficit		(9,341	)		(2,016	)

Total stockholders’ equity		183,592			191,228

	$	268,769		$	261,983

	Three months ended December 31,
	2002			2001
Revenues:
License	$	13,423		$	23,216
Maintenance and services		13,674			16,831

Total revenues		27,097			40,047

Cost of revenues:
License		1,076			1,595
Maintenance and services		3,289			5,208

Total cost of revenues		4,365			6,803

Gross profit		22,732			33,244

Operating expenses:
Sales and marketing		14,442			18,085
Research and development		7,421			7,570
General and administrative		4,066			4,938
Amortization of goodwill and other intangible assets		1,552			2,767
Purchased in-process research and development		142			—
Restructuring costs		3,329			—
Executive recruiting costs		—			449

Total operating expenses		30,952			33,809

Loss from operations		(8,220	)		(565	)
Other income, net		1,380			1,608

Income (loss) before income taxes		(6,840	)		1,043
Income tax provision		485			427

Net income (loss)	$	(7,325	)	$	616

Per share data:
Basic net income (loss)	$	(0.10	)	$	0.01
Diluted net income (loss)	$	(0.10	)	$	0.01
Weighted average shares used in computing:
Basic net income (loss) per share		75,241			74,043
Diluted net income (loss) per share		75,241			78,246

	Three months ended December 31,
	2002			2001
Cash flows from operating activities:
Net income (loss)	$	(7,325	)	$	616
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		3,654			5,066
Purchased in-process research & development		142			—
Non-cash compensation expense related to restructuring		54			—
Non-cash compensation expense related to issuance of warrant		—			170
Tax benefit related to exercise of stock options		203			—
Changes in operating assets and liabilities net of acquired amounts:
Billed receivables, net		5,888			2,003
Prepaid expenses and other current assets		208			2,789
Accounts payable		457			508
Accrued expenses		438			(2,970	)
Income taxes payable		65			688
Deferred revenue		12,483			(621	)

Net cash provided by operating activities		16,267			8,249

Cash flows from investing activities:
Capital expenditures		(216	)		(1,073	)
Investment proceeds, net		5,154			(2,376	)
Acquisition of net assets, net of cash acquired		(2,008	)		—

Cash provided by (used in) investing activities		2,930			(3,449	)

Cash flows from financing activities:
Proceeds from issuance of common stock		155			1,587

Net cash provided by financing activities		155			1,587

Effects of exchange rate changes on cash and cash equivalents		(1,100	)		(807	)

Net increase in cash and cash equivalents		18,252			5,580
Cash and cash equivalents at beginning of period		117,218			138,581

Cash and cash equivalents at end of period	$	135,470		$	144,161

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	Three months ended December 31,
	2002		2001
Revenues:
United States	$	18,851	$	21,277
United Kingdom		2,114		4,820
Other international		6,132		13,950

Total	$	27,097	$	40,047


	December 31, 2002		September 30, 2002
Long—lived assets:
United States	$	31,381	$	30,710
Other international		18,233		19,490

Total	$	49,614	$	50,200

	Three months ended December 31,
	2002			2001
Net income (loss)—as reported	$	(7,325	)	$	616
Adjustments:
Amortization of goodwill		—			1,717
Amortization of assembled workforce		—			101

Net adjustments		—			1,818

Net income (loss)—as adjusted	$	(7,325	)	$	2,434

Basic and diluted net income (loss) per common share—as reported	$	(0.10	)	$	0.01
Basic and diluted net income (loss) per common share—as adjusted	$	(0.10	)	$	0.03
Weighted average common shares outstanding used in calculating net income (loss) per common share
Basic		75,241			74,043
Diluted		75,241			78,246

Total tangible liabilities, net	$	(1.3	)
Intangible assets:
In-process research and development		0.1
Developed technology		1.2
Customer contracts		0.2
Goodwill		0.8

Total intangible assets		2.3

Total	$	1.0

	Quarter ended December 31,
	2002			2001
	(unaudited)
Revenues	$	27,949		$	41,100
Net loss	$	(8,038	)	$	(388	)
Net loss per share:
Basic	$	(0.11	)	$	(0.01	)
Diluted	$	(0.11	)	$	(0.01	)
Shares used in per share computation:
Basic		75,241			74,043
Diluted		75,241			74,043

	Fiscal 2002 Restructuring Plan				Fiscal 2003 Restructuring Plan Severance		Total
	Facility		Severance		Fiscal 2003 Restructuring Plan Severance		Total
Accrual balance at September 30, 2002	$	971	$	1,447	$	—	$	2,418
Restructuring Charges		—		—		3,329		3,329
Amount Utilized:
Cash Paid		218		518		1,254		1,990
Non cash charges		51		—		54		105

Accrual balance at December 31, 2002	$	702	$	929	$	2,021	$	3,652

Votes For		65,243,895
Votes Against		1,616,360
Votes Abstaining		16,755
Broker Non-Votes		0

Exhibit Number		Description
3.1		Restated Certificate of Incorporation of the Registrant (incorporated by reference from exhibit 3.1 in our Form 10-K filed with the SEC on December 21, 2001).

3.2		Amended and Restated Bylaws of the Registrant (incorporated by reference from exhibit 3.2 in our amended registration statement on Form S-1, No. 333-58975, as filed with the SEC on July 13, 1998).

10.14		Employment Continuation Agreement by and between Michael Foster and Micromuse Inc*

99.1		Certification of Principal Executive and Financial Officer of Registrant required by Section 906 of the Sarbanes-Oxley Act of 2002