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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended January 3, 2004

Commission file number 000-29309

MATRIXONE, INC.

(Exact Name of Registrant as Specified in Its Charter)

210 Littleton Road

Westford, Massachusetts 01886

(Address of Principal Executive Offices, Including Zip Code)

(978) 589-4000

(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x No ¨

As of February 9, 2004, there were 48,380,101 shares of common stock, $0.01 par value per share, outstanding.

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MATRIXONE, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE FISCAL QUARTER ENDED JANUARY 3, 2004

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PART I - FINANCIAL INFORMATION

MATRIXONE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

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

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MATRIXONE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(unaudited)

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

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MATRIXONE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)

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

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share amounts)

Note 1. Summary of Significant Accounting Policies

Basis of Presentation and Principles of Consolidation

The accompanying condensed consolidated financial statements of MatrixOne, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States. These accounting principles were applied on a basis consistent with those of the consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended June 28, 2003 filed with the Securities and Exchange Commission (the “SEC”). The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended June 28, 2003. In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments (consisting only of normal, recurring adjustments, except for the asset impairment and disposal charges and restructuring charges in Note 3 and Note 4, respectively) necessary for a fair presentation. The operating results for the three month and six month periods ended January 3, 2004 may not be indicative of the results expected for any succeeding quarter or the entire fiscal year ending July 3, 2004.

The Company operates on a 52 or 53 week fiscal year that ends on the Saturday closest to June 30^th and on thirteen or fourteen week fiscal quarters that end on the Saturday closest to September 30^th, December 31^st and March 31^st. The fiscal quarter ended January 3, 2004 consisted of fourteen weeks, and the fiscal year ending July 3, 2004 will consist of 53 weeks. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments, which are evaluated on an on-going basis, that affect the amounts reported in the Company’s condensed consolidated financial statements and accompanying notes. Management bases its estimates on historical experience and on various other assumptions that it believes are 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 could differ from those estimates and judgments. In particular, significant estimates and judgments include those related to revenue recognition, allowance for doubtful accounts, valuation of prepaid software royalty fees, useful lives of property and equipment, valuation of deferred tax assets and software license and professional services warranty.

Concentrations of Credit Risk and Significant Customers

No customer represented more than 10% of the Company’s total revenues for the three or six month periods ended January 3, 2004 and December 28, 2002. One customer represented 12.6% of the Company’s accounts receivable at January 3, 2004, and one other customer represented 10.2% of the Company’s accounts receivable at December 28, 2002.

Note 2. Other Assets

At January 3, 2004, other assets included a long-term accounts receivable from a customer due on September 16, 2005 of $1,460. The software license revenue related to this long-term accounts receivable, which is included in deferred revenue, will be recognized when payment becomes due on September 16, 2005, assuming any remaining contractual obligations have been met and collectibility is probable.

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (continued)

(In thousands, except per share amounts)

Note 3. Asset Impairment and Disposal Charges

In conjunction with the October 2003 restructuring program (Note 4), the Company evaluated the recoverability of certain of its assets. Based on this evaluation, the Company determined that certain capitalized software would not be recoverable due to the Company’s inability to utilize and maintain this software as a result of the termination of certain operational and technical personnel and the reorganization of certain departments. Accordingly, the Company recorded an asset impairment charge of $1,209, which represented the net book value of this software as of the evaluation date. In addition, in conjunction with the closure and consolidation of certain office facilities, the Company abandoned or disposed of certain office equipment and leasehold improvements that could not be transferred to or used by the remaining offices and recorded an asset abandonment and disposal charge of $471, which represented the net book value of these assets on the date of the abandonment or disposal.

Note 4. Restructuring Charges

October 2003 Restructuring Program

As a result of disappointing financial results for the three months ended September 27, 2003 and continued weakness in information technology spending and global economic conditions and the related impact on the Company’s business, in October 2003 the Company implemented a restructuring program to further reduce expenses to align its operations and cost structure with current and projected market conditions (the “October 2003 restructuring program”). This restructuring program primarily included a reduction in the number of employees across all functions and locations and the closure and consolidation of certain offices.

The October 2003 restructuring program included a reduction in workforce of 45 employees, including 10 employees in cost of service revenues, 16 employees in selling and marketing, 13 employees in research and development and six employees in general and administration. The costs related to the reduction in workforce include severance, fringe benefits and other related costs. These severed employees were not required to render service in order to receive termination benefits and were not required to render service beyond the minimum retention period.

The October 2003 restructuring program also included costs related to the closure and consolidation of certain office facilities. During the three months ended January 3, 2004, the Company vacated these offices and entered into agreements with the lessors to terminate the leases before the original lease term and paid a lease termination fee. In conjunction with the consolidation of certain offices, the Company also incurred certain costs to relocate employees and office furniture and equipment.

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (continued)

(In thousands, except per share amounts)

The significant components of the October 2003 restructuring program and the related restructuring charges, cash payments and the remaining accrual as of January 3, 2004 were as follows:

The October 2003 restructuring program was substantially completed during the three months ended January 3, 2004, and the remaining cash payments are expected to be made through February 28, 2004.

April 2003 Restructuring Program

In April 2003, the Company reorganized certain of its operations to reduce expenses and to better align its management structure with its strategic initiatives (the “April 2003 restructuring program”). The April 2003 restructuring program consisted of the elimination of certain positions within the Company, primarily at the Vice President and Director level.

The April 2003 restructuring program included a reduction in workforce of 13 employees, consisting of seven employees in selling and marketing, four employees in research and development and two employees in general and administration. The costs related to the reduction in workforce include severance, fringe benefits and other related costs. These severed employees were not required to render service in order to receive termination benefits and were not required to render service beyond the minimum retention period.

The significant components of the April 2003 restructuring program and the related restructuring charges, non-cash adjustments, cash payments and the remaining accrual as of January 3, 2004 were as follows:

The non-cash adjustments during fiscal 2004 reflect additional employee severance related costs. The April 2003 restructuring program was substantially completed during fiscal 2003, and the remaining cash payments are expected to be made through June 30, 2004.

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (continued)

(In thousands, except per share amounts)

October 2002 Restructuring Program

As a result of continued weakness in information technology spending and global economic conditions and the related impact on the Company’s business, in October 2002 the Company implemented a restructuring program to reduce expenses to align its operations and cost structure with market conditions (the “October 2002 restructuring program”). This restructuring program primarily included a reduction in the number of employees across all functions and locations, a reduction in the use of independent contractors across all functions and locations and the closure of excess facilities.

The October 2002 restructuring program included a reduction in workforce of 86 employees, consisting of 32 employees in cost of service revenues, 28 employees in selling and marketing, 17 employees in research and development and nine employees in general and administration. The costs related to the reduction in workforce include severance, fringe benefits and other related costs.

The October 2002 restructuring program also included facility and lease costs related to the closure of certain excess facilities that the Company has exited and the termination of certain automotive lease contracts.

The significant components of the October 2002 restructuring program and the related restructuring charges, non-cash adjustments, cash payments and the remaining accrual as of January 3, 2004 were as follows:

The non-cash adjustments during fiscal 2004 reflect an unfavorable final settlement for an employee severance arrangement and favorable final settlement for certain lease arrangements. The October 2002 restructuring program was substantially completed during fiscal 2003, and the remaining cash payments are expected to be made through April 30, 2004.

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (continued)

(In thousands, except per share amounts)

Note 5. Software License and Professional Services Warranty

The Company generally provides a 90 day warranty on its software products. The Company’s software products are generally warranted to perform in all material aspects as described in the applicable software product documentation, and the media in which the software is delivered is warranted to be free of defects in materials and workmanship under normal use. To date, our software product warranty expense has not been material.

The Company’s professional services are generally warranted to be performed in a workmanlike manner. In the event the customer requests the work be corrected, the Company generally will provide these additional professional services at no charge to comply with the Company’s warranty obligations and to ensure customer satisfaction.

The Company records an estimate of professional services warranty based on historical activity. Warranty expense is included in cost of services and the related liability is included in accrued liabilities. The Company primarily satisfies its warranty obligations by providing in-kind services. The activity related to the Company’s warranty accrual is presented below.

Note 6. Commitments and Contingencies

Contingencies

On April 19, 2002, a consolidated amended class action complaint was filed in the United States District Court for the Southern District of New York. The complaint, which superseded five virtually identical complaints that had been filed from July 24, 2001 to September 5, 2001, names as defendants the Company, two of its officers, and certain underwriters involved in the Company’s initial public offering of common stock (“IPO”). The complaint is allegedly brought on behalf of purchasers of the Company’s common stock during the period from February 29, 2000 to December 6, 2000 and asserts, among other things, that the Company’s IPO prospectus and registration statement violated federal securities laws because they contained material misrepresentations and/or omissions regarding the conduct of the Company’s IPO underwriters in allocating shares in the Company’s IPO to the underwriters’ customers, and that the Company and the two named officers engaged in fraudulent practices with respect to the underwriters’ conduct. The action seeks damages, fees and costs associated with the litigation, and interest. The Company and its officers and directors believe that the allegations in the complaint are without merit and have defended the litigation vigorously. The litigation process is inherently uncertain and unpredictable, however, and there can be no guarantee as to the ultimate outcome of this pending lawsuit. Pursuant to a stipulation between the parties, the Company’s two named officers were dismissed from the lawsuit, without prejudice, on October 9, 2002. On February 19, 2003, the Court ruled on a motion to dismiss the complaint that had been filed by the Company, along with the three hundred plus other publicly-traded companies that have been named by various plaintiffs in substantially similar lawsuits. The Court granted the Company’s motion to dismiss the claim filed against it under Section 10(b) of the Securities Exchange Act of 1934, but denied the Company’s motion to dismiss the claim filed against it under Section 11 of the

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (continued)

(In thousands, except per share amounts)

Securities Act of 1933, as it denied the motions under this statute for virtually every other company sued in the substantially similar lawsuits.

In June 2003, the Company, implementing the determination made by a special independent committee of the Board of Directors, elected to participate in a proposed settlement agreement with the plaintiffs in this litigation. If ultimately approved by the Court, this proposed settlement would result in a dismissal, with prejudice, of all claims in the litigation against the Company and against any of the other issuer defendants who elect to participate in the proposed settlement, together with the current or former officers and directors of participating issuers who were named as individual defendants. The proposed settlement does not provide for the resolution of any claims against the underwriter defendants, and the litigation as against those defendants is continuing. The proposed settlement provides that the class members in the class action cases brought against the participating issuer defendants will be guaranteed a recovery of $1.0 billion by insurers of the participating issuer defendants. If recoveries totaling $1.0 billion or more are obtained by the class members from the underwriter defendants, however, the monetary obligations to the class members under the proposed settlement will be satisfied. In addition, the Company and any other participating issuer defendants will be required to assign to the class members certain claims that they may have against the underwriters of their IPOs.

The proposed settlement contemplates that any amounts necessary to fund the settlement or settlement-related expenses would come from participating issuers’ directors and officers liability insurance policy proceeds as opposed to funds of the participating issuer defendants themselves. A participating issuer defendant could be required to contribute to the costs of the settlement if that issuer’s insurance coverage were insufficient to pay that issuer’s allocable share of the settlement costs. The Company expects that its insurance proceeds will be sufficient for these purposes and that it will not otherwise be required to contribute to the proposed settlement. Consummation of the proposed settlement is conditioned upon, among other things, negotiating, executing, and filing with the Court final settlement documents, and final approval by the Court. If the proposed settlement described above is not consummated, the Company intends to continue to defend the litigation vigorously. Moreover, if the proposed settlement is not consummated, the Company believes that the underwriters may have an obligation to indemnify the Company for the legal fees and other costs of defending this suit. While the Company cannot guarantee the outcome of these proceedings, the Company believes that the final result of these actions will have no material effect on its consolidated financial condition, results of operations or cash flows.

Indemnifications

The Company licenses software and sells services to its customers pursuant to contracts, which the Company refers to as a Software License Agreement (“SLA”) and Master Services Agreement (“MSA”), respectively. Each SLA and MSA contains the relevant terms of the contractual arrangement with the customer and generally includes certain provisions for indemnifying the customer against losses, expenses, and liabilities from damages that are finally awarded against the customer by a court of competent jurisdiction or that are agreed to by the Company in a written settlement agreement in the event the Company’s software or services performed by the Company is found to infringe upon a patent, copyright, trademark, or other proprietary right of a third-party. The SLA and MSA generally limit the scope of and remedies for such indemnification obligations in a variety of industry-standard respects, including but not limited to, certain time and geography based scope limitations and a right to replace an infringing product.

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (continued)

(In thousands, except per share amounts)

The Company believes its internal development processes and other policies and practices limit its exposure related to the indemnification provisions of the SLA and MSA. In addition, the Company requires its employees to sign a proprietary information and inventions agreement, which assigns the rights of its employees’ development work to the Company. To date, the Company has not had to reimburse any of its customers for any losses related to these indemnification provisions and no material claims are outstanding as of January 3, 2004. For several reasons, including the lack of prior indemnification claims and the lack of a monetary liability limit for certain infringement cases under the SLA and MSA, the Company cannot determine the maximum amount of potential future payments, if any, related to such indemnification provisions.

Note 7. Line of Credit

On December 23, 2003, the Company amended its $10,000 line of credit to extend the term of the agreement through December 26, 2004. The line of credit bears interest at the bank’s prime rate plus 0.5% per annum on any outstanding balances. As of January 3, 2004, the Company had no borrowings outstanding under this line of credit and $10,000 available.

Note 8. Stockholders’ Equity

On January 21, 2003, the Board of Directors (the “Board”) approved a stock repurchase program (the “Program”) whereby the Company may repurchase up to $10,000 of its common stock, $0.01 par value per share (the “common stock”). Common stock repurchases under the Program may be made in the open market, through block trades or otherwise during the one year period that began on January 27, 2003. During the three and six month periods ended January 3, 2004, the Company did not purchase or retire any shares of its common stock under the Program. The Program terminated on January 26, 2004.

On February 3, 2003, the Company announced that the Board approved a voluntary stock option exchange program (the “option exchange program”). The option exchange program provided eligible holders of outstanding, unexercised options to purchase shares of the Company’s common stock issued pursuant to the Company’s Third Amended and Restated 1996 Stock Plan (the “1996 Plan”) and the Company’s Amended and Restated 1999 Stock Plan (the “1999 Plan”) with an exercise price of at least $5.00 per share the opportunity to tender such options in exchange for new replacement options. The ratios of new replacement options to options tendered pursuant to the option exchange program were as follows: 4 for 5 for options with exercise prices of $5.00 to $9.99; 3 for 5 for options with exercise prices of $10.00 to $19.99; and 2 for 5 for options with exercise prices of $20.00 or more. Members of the Company’s Board and the Company’s executive officers were not eligible to participate in the option exchange program. Options to purchase approximately 2,597 shares of the Company’s common stock were tendered and cancelled on March 6, 2003 pursuant to the option exchange program, and the Company granted new replacement options to purchase an aggregate of approximately 1,216 shares of its common stock at an exercise price of $5.92 per share on September 8, 2003 in exchange for the tendered and cancelled options. The new replacement options had an exercise price equal to the fair market value of the Company’s common stock on the date the new replacement options were granted and vest quarterly over a 30-month period. The Company did not record any stock-based compensation expense as a result of the option exchange program.

On November 7, 2003, the shareholders of the Company approved an amendment to the 1999 Plan to increase the number of shares of common stock that may be issued pursuant to the 1999 Plan by 2,000 shares to 8,000 shares of common stock in the aggregate. At the same time, the shareholders of the Company also approved an amendment to the Company’s 2000 Employee Stock Purchase Plan (the “2000 Plan”) to increase the number of shares of common stock that may be issued pursuant to the 2000 Plan by 650 shares to 2,000 shares of common stock in the aggregate.

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (continued)

(In thousands, except per share amounts)

Pursuant to the 1996 Plan and 1999 Plan, the Company may grant incentive and nonqualified stock options, stock issuances and opportunities to make direct purchases of stock to employees, officers or consultants of the Company. The Company records stock-based compensation issued to employees and directors (collectively “employees”) using the intrinsic value method and stock-based compensation issued to non-employees using the fair value method. Stock-based compensation is recognized on stock options issued to employees if the option exercise price is less than the market price of the underlying stock on the date of grant, and stock-based compensation is recognized on all stock options granted to non-employees. During the periods presented, no stock options were issued to employees at an exercise price less than the market price of the underlying stock on the date of grant, and no stock options were issued to non-employees. Accordingly, no stock-based compensation expense was recorded pursuant to stock options granted during the periods presented.

The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of the Company’s stock options.

The fair value of stock options granted during the periods indicated have been determined using the Black-Scholes option pricing model and the following assumptions:

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (continued)

(In thousands, except per share amounts)

Had compensation expense for all stock options been determined based on fair value as prescribed by Statement of Financial Accounting Standards No. 123, the Company’s pro forma net loss and pro forma basic and diluted net loss per share would have been as follows:

In connection with certain stock option grants to employees in fiscal 2000 and 1999, the Company recorded deferred stock-based compensation totaling $17,654. Deferred stock-based compensation represents the difference between the option exercise price and the deemed fair value of the Company’s common stock on the date of grant. Deferred stock-based compensation, a component of stockholders’ equity, is amortized through charges to operations over the vesting period of the options, which is generally four years. Stock-based compensation was $188 and $831 for the three months ended January 3, 2004 and December 28, 2002, respectively, and $567 and $1,695 for the six months ended January 3, 2004 and December 28, 2002. The amortization of deferred stock-based compensation ended during the three month period ended January 3, 2004.

Note 9. Basic and Diluted Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the shares used in the calculation of basic net income (loss) per share plus the dilutive effect of common stock equivalents, such as stock options, using the treasury stock method. Common stock equivalents are excluded from the computation of diluted net income (loss) per share if their effect is antidilutive.

Potentially dilutive common stock options aggregating 10,065 and 10,766 shares for the three months ended January 3, 2004 and December 28, 2002, respectively, and 10,261 and 11,058 shares for the six months ended January 3, 2004 and December 28, 2002, respectively, have been excluded from the computation of diluted net loss per share because their inclusion would be antidilutive.

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MATRIXONE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (continued)

(In thousands, except per share amounts)

Note 10. Comprehensive Loss

Comprehensive loss includes net loss and other changes in stockholders’ equity, except for stockholders’ investments and distributions, repurchases of common stock and deferred stock-based consideration. The components of comprehensive loss were as follows:

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This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are subject to a number of risks and uncertainties. These forward-looking statements are typically denoted in this Quarterly Report on Form 10-Q by the phrases “anticipates,” “believes,” “expects,” “plans” and similar phrases (as well as other words or expressions referencing future events, conditions or circumstances). Our actual results could differ materially from those projected in the forward-looking statements as a result of various factors, including the factors set forth in “Cautionary Statements” beginning on page 35 of this Quarterly Report on Form 10-Q. This discussion should be read in conjunction with the condensed consolidated financial statements and related notes for the periods specified. Further reference should be made to the Company’s Annual Report on Form 10-K for the fiscal year ended June 28, 2003.

Business Overview

MatrixOne, Inc. is a provider of product life cycle management (“PLM”) solutions. Our solutions enable companies from a broad range of industries to accelerate product innovation and time-to-market by collaboratively managing product development efforts. These interoperable solutions bring together people, processes, content, and systems throughout global value chains of employees, customers, suppliers and partners to achieve a competitive advantage by bringing the right products and services to market cost-effectively. By unifying and streamlining processes across the product lifecycle, companies can easily work on projects with parties inside and outside of their enterprises to achieve greater efficiency and profitability. In addition, our technology enables companies to adapt, react and scale quickly to address their ever-changing business requirements.

Our PLM solutions are based on our suite of software products, collectively referred to as Matrix10^™. Our Matrix10 solution is a comprehensive and flexible PLM environment that consists of four components: the Matrix PLM Platform^™, Collaborative Applications^™, Lifecycle Applications^™ and enterprise interoperability products. We offer a variety of services that complement our PLM software. Our professional services personnel provide rapid and cost-effective implementation, integration and other consulting services. These personnel capture and model the specific business processes that reflect our customers’ planning, design, manufacturing, sales and service practices. We also provide training and maintenance and customer support services to continuously enhance the value of our products to our customers. In addition, we have a global network of systems integrators who are experienced in providing implementation and integration services to our customers. Many of our customers use their preferred systems integrators or perform their own implementation.

Our strategy for long-term, sustainable growth in revenue and earnings is focused on achieving a leadership position within the PLM market by effectively enabling our customers to achieve measurable improvements in their business by unifying and streamlining processes across the product lifecycle. Currently, there are three key elements to our growth strategy: improving sales execution, upgrading our installed base of customers to Matrix10 and extending our position in core industrial markets.

We are intensely focused on improving all elements of company-wide sales execution. We have implemented a common, disciplined selling process in all regions of the world, which we believe will lead to improved visibility of future revenue opportunities and improved accuracy in revenue forecasting. We are increasingly working more effectively with our global alliance partners whom we depend on to deliver the comprehensive needs of our global customer base.

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In May 2003, we introduced Matrix10, a comprehensive and flexible PLM environment that consists of four components: the Matrix PLM Platform, Collaborative Applications, Lifecycle Applications and enterprise interoperability products. Matrix10 includes significant enhancements in security, scalability, and interoperability compared to previous releases of our product offerings. Because many of our existing customers operate with previous releases of our products, we believe that there are opportunities to grow software license and professional services revenue by effectively upgrading our installed base of customers to Matrix10.

We license our PLM solutions into eight industrial markets including aerospace and defense, automotive, consumer products, financial services, machinery, high technology, medical devices, and the process industries. To gain market leadership in each of these industrial markets, a core part of our growth strategy is to: develop and market focused variations of our core product offerings to meet the needs of industry-specific business processes; develop the deep domain expertise of our workforce in the industrial markets in which we compete; and develop and leverage alliance partnerships with key system integration partners, original equipment manufacturers, and complementary hardware and software providers.

Financial Overview

We generate revenues from licensing our software and providing professional services, training and maintenance and customer support services through our offices in the United States, Canada, England, France, Germany, Italy, Japan, Korea, Singapore and the Netherlands and indirectly through our Alliance Partner network throughout Europe and Asia/Pacific. Revenues by geographic region fluctuate each period based on the timing, size and number of software license and professional services transactions and fluctuation in the value of foreign currencies relative to the U.S. Dollar. We expect our revenues by geographic region to continue to fluctuate in the future. Our total revenues by major geographical region, including exports into such regions, for the three and six month periods ended January 3, 2004 and December 28, 2002 were as follows:

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We operate on a 52 or 53 week fiscal year that ends on the Saturday closest to June 30^th and on thirteen or fourteen week fiscal quarters that end on the Saturday closest to September 30^th, December 31^st and March 31^st. The fiscal quarter ended January 3, 2004 consisted of fourteen weeks, and the fiscal year ending July 3, 2004 will consist of 53 weeks. Accordingly, our results for the three and six month periods ended January 3, 2004 include one additional week of expenses. This fact should be considered when assessing the comparative financial results set forth in the following discussion of our results of operations.

As a result of disappointing financial results for the three months ended September 27, 2003 and continued weakness in information technology spending and global economic conditions and the related impact on our business, in October 2003, we implemented a restructuring program to further reduce expenses to align our operations and cost structure with current and projected market conditions and recorded a restructuring charge of $1.8 million. This restructuring program primarily included a reduction in workforce of 45 employees across all functions and locations and the closure and consolidation of certain offices. In addition, in conjunction with this restructuring program, we evaluated the recoverability of certain of our assets and determined that certain capitalized software, office equipment and leasehold improvements would not be recoverable. Accordingly, we recorded asset impairment and disposal charges of $1.7 million. Since October 2001, we have implemented several restructuring programs to adjust our operations and cost structure as a result of the weak information technology market and general global economic conditions. As a result of these programs, we have reduced our workforce from a high of 614 employees as of September 29, 2001 to our current workforce of 390 employees as of January 3, 2004. However, certain of these cost savings resulting from our restructuring programs have been offset by increased expenses due to the strengthening of major foreign currencies relative to the U.S. Dollar as discussed above.

We have incurred significant costs to develop our technology and products, market, license, sell, implement and support our products and services, and maintain an infrastructure to support our global operations. These costs have historically exceeded our total revenues. As of January 3, 2004, we had an accumulated deficit of approximately $97.0 million. We anticipate that our operating expenses in fiscal 2004 will exceed projected revenues. Accordingly, we expect to incur a net loss in fiscal 2004. In addition, if our operating expenses are higher than we anticipate or our revenues are lower than projected, we may incur significant net losses in fiscal 2004 and in the future.

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Critical Accounting Policies and Estimates

This discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments, which we evaluate on an on-going basis, that affect the reported amounts of assets, liabilities, revenues and expenses. We base our estimates on historical experience and on various other assumptions that we believe are 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 and judgments under different assumptions or conditions.

We believe the following sets forth the most important accounting policies we used in the preparation of our condensed consolidated financial statements and those that affect our more significant estimates and judgments, which have been reviewed by our Disclosure Committee, consisting primarily of our senior management team, and the Audit Committee of our Board of Directors.

Revenue Recognition

We generate revenues from licensing our software and providing professional services, training and maintenance and customer support services. We execute separate contracts that govern the terms and conditions of each software license and maintenance arrangement and each professional services arrangement. These contracts may be an element in a multiple-element arrangement. Revenues under multiple-element arrangements, which may include several different software products or services sold together, are allocated to each element using the residual method.

We use the residual method when fair value does not exist for one of the delivered elements in an arrangement. Under the residual method, the fair value of the undelivered elements is deferred and subsequently recognized. We have established sufficient vendor specific objective evidence of fair value for professional services, training and maintenance and customer support services based on the price charged when these elements are sold separately. Accordingly, software license revenue is recognized under the residual method in arrangements in which software is licensed with professional services, training or maintenance and customer support services.

We recognize software license revenues upon execution of a signed license agreement, delivery of the software to a customer and determination that collection of a fixed license fee is probable. For delivery over the Internet, the software license is considered delivered when the customer is provided access to the software files.

In accordance with our agreements with our value-added resellers and distributors (“Alliance Partners”), an Alliance Partner has the right to license our software to its customers (“end users”). Therefore, we have no obligation to the Alliance Partner’s end users. Accordingly, we recognize software license revenues from an Alliance Partner upon receipt of a written confirmation from the Alliance Partner of a noncancellable, binding written arrangement with the ultimate end user and delivery of the software to the Alliance Partner.

We recognize revenue from software subscription arrangements ratably over the term of the contract on a straight-line basis. Fees from revenue sharing, royalty and subscriber arrangements with and through third-parties are recognized as revenue when they are fixed and determinable, generally upon receipt of a statement from the third-party.

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Service revenues include professional services, reimbursements received for out-of-pocket expenses incurred, training and maintenance and customer support fees. Professional services are not essential to the functionality of the other elements in an arrangement and are accounted for separately. Professional services revenues are primarily derived from time and material contracts and are recognized as the services are performed. Professional services revenues for fixed-price contracts are recognized using a concept of proportional performance based upon the ratio of direct labor costs to expected labor costs. If conditions for acceptance are required, professional services revenues are recognized upon customer acceptance. Our customers generally reimburse us for the majority of our out-of-pocket expenses incurred during the course of an engagement. We do not mark-up or add additional fees to the actual out-of-pocket expenses we incur. Training revenues are recognized as the services are provided.

For arrangements that include the licensing of software and the performance of professional services under a fixed-price contract, both the software license revenues and professional services revenues are recognized using a concept of proportional performance based upon the ratio of direct labor costs to expected labor costs.

Maintenance and customer support fees include the right to unspecified upgrades on a when-and-if-available basis and ongoing technical support. Maintenance and customer support fees are recognized ratably over the term of the contract, generally one year, on a straight-line basis. When a maintenance and customer support fee is included with a software license fee, we allocate a portion of the software license fee to maintenance and customer support fees based on the renewal rate of maintenance and customer support fees.

Allowance for Doubtful Accounts

We periodically assess the collectibility of customer accounts receivable. We maintain an allowance for estimated losses resulting from uncollectible customer accounts receivable. In estimating this allowance, we consider customer specific factors such as historical collection experience, current credit worthiness, the aggregate amount due, age of the receivable and general economic conditions that may affect a customer’s ability to pay. We also consider factors such as the overall balance and aging of our accounts receivable, as well as customer and geographic concentrations. Actual customer collections could differ materially from our estimates. The use of different estimates or assumptions could produce a materially different allowance. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. As a result of lower total revenues and accounts receivable, and improvement in the aging of our accounts receivable and the days of our sales outstanding over the past several quarters, we revised our estimate of doubtful accounts and as a result decreased our allowance for doubtful accounts by $0.3 million and $0.5 million during the three and six month periods ended January 3, 2004. Our allowance for doubtful accounts was $1.7 million and $2.2 million at January 3, 2004 and June 28, 2003, respectively.

Prepaid Software Royalty Fees

Prepaid software royalty fees, which are included in prepaid expenses and other current assets, are paid to third-party software developers under contractual arrangements for technology integrated into certain of our Collaborative Applications, Lifecycle Applications and enterprise interoperability products. Amortization of prepaid software royalty fees commences when the software is available for general release. We amortize prepaid software royalty fees to cost of software license revenues based on the greater of the actual royalties incurred to date or the straight-line method of amortization over the estimated useful life of the software product, which is generally two or three years. Management regularly reviews the valuation of each prepaid software royalty fee in order to determine if events and circumstances may require a change in such valuation to reflect the estimated recoverable amount. Prepaid software royalty fees aggregated $2.1 million and $3.6 million at January 3, 2004 and June 28, 2003, respectively.

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Property and Equipment

We estimate the useful lives of our property and equipment, and we record depreciation on a straight-line basis over the estimated useful lives of our property and equipment. We regularly review our estimate of the useful lives and net book value of our property and equipment in order to determine if events and circumstances, such as changes in technology, product obsolescence and changes in our business, may require a change in the estimated useful lives of our property and equipment or recognition of an impairment loss, both of which would increase our operating expenses.

As a result of our restructuring program in October 2003, we evaluated the recoverability of certain of our assets. Based on this evaluation, we determined that certain assets would not be recoverable, and we recorded an asset impairment charge of $1.7 million. For additional information regarding this impairment charge, refer to Note 3 to our condensed consolidated financial statements included in Part I, Item 1 in this Quarterly Report on Form 10-Q.

Deferred Tax Assets

We record a valuation allowance, in accordance with GAAP, to reduce our deferred tax assets to the estimated amount that is more likely than not to be realized. During our assessment of the valuation allowance, we consider future taxable income and ongoing tax planning strategies on a consolidated basis and in the tax jurisdictions in which we operate. We have recorded a valuation allowance against our deferred tax assets due to the fact it is more likely than not that the deferred tax assets will not be realized. We regularly evaluate the realizability of our deferred tax assets and may adjust the valuation allowance based on such analysis.

Software License and Professional Services Warranty

We generally provide a 90 day warranty on our software products. Our software products are generally warranted to perform in all material aspects as described in the applicable software product documentation and the media in which the software is delivered is warranted to be free of defects in materials and workmanship under normal use. To date, our software product warranty expense has not been material.

Our professional services are generally warranted to be performed in a workmanlike manner. In the event the customer requests the work be corrected, we generally will provide these additional professional services at no charge to comply with our warranty obligations and to ensure customer satisfaction.

We provide for an estimate of professional services warranty based on historical activity. Warranty expense is included in cost of services. If our actual warranty activities differ from our estimates, revisions to the estimated warranty liability would be required and result in additional charges to cost of services. We primarily satisfy our warranty obligations by providing in-kind services. Our warranty accrual was $0.9 million at January 3, 2004 and June 28, 2003. For additional information regarding the activity related to our warranty accrual, refer to Note 5 to our condensed consolidated financial statements included in Part I, Item 1 in this Quarterly Report on Form 10-Q.

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Results of Operations

The following table sets forth certain statements of operations data as a percentage of total revenues for the periods indicated. The data has been derived from the unaudited condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q. The operating results for any period should not be considered indicative of the results expected for any future period. This information should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 28, 2003.

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Comparison of the Three Months Ended January 3, 2004 and December 28, 2002

Software license revenues. We derive our software license revenues principally from licensing our suite of software products including our Matrix PLM Platform, Collaborative Applications, Lifecycle Applications and enterprise interoperability products.

Software license revenues from our suite of software products, the number of software license transactions and the number of software license transactions in excess of $1.0 million for the three months ended January 3, 2004 and December 28, 2002 were as follows:

Software license revenues by geographic region for the three months ended January 3, 2004 and December 28, 2002 were as follows: