Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

For the quarterly period ended June 30, 2004

OR

Commission File Number: 0-27696

GENSYM CORPORATION

(Exact name of registrant as specified in its charter)

52 Second Avenue

Burlington, MA 01803

(Address of principal executive offices)

Telephone Number (781) 265-7100

(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 checkmark whether the registrant is an accelerated filer (as defined in Rule 12-b-2 of the Exchange Act)    Yes  ¨    No  x

As of August 16, 2004 there were 7,224,756 shares of the Registrant’s Common Stock outstanding.

Table of Contents

GENSYM CORPORATION

INDEX

2

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. Consolidated Financial Statements

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share amounts)

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

3

Table of Contents

GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)

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

4

Table of Contents

GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

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

5

Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Operations

We are a provider of operations management and expert systems software products and services. Our products emulate the reasoning of human experts, using process knowledge and often real-time data, and then, on the basis of such reasoning, make recommendations or take direct operational actions. Most applications of our products are in the areas of abnormal condition and process performance management in manufacturing, supply chain and logistics management, and network management. Benefits derived from the use of our products include waste reduction, avoidance of off-specification product, avoidance of system downtime in mission-critical networks, and proactive alarms that signify potential process problems and avoid plant shutdowns. Our products have been used in the manufacturing, transportation, communications, aerospace and government sectors for many years.

2. Basis of Presentation

We have prepared the unaudited consolidated financial statements included in this report pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. Certain information and footnote disclosures, normally included in financial statements prepared for the full year in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to such SEC rules and regulations; nevertheless, our management believes that the disclosures in this report are adequate to make the information presented not misleading. In the opinion of management, the consolidated financial statements reflect all adjustments (of a normal and recurring nature) that are necessary to present fairly our consolidated financial position as of June 30, 2004 and our results of operations and cash flows for the three- and six- month periods ended June 30, 2004 and 2003. These consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003, filed with the SEC on March 30, 2004. The results of operations for interim periods are not necessarily indicative of the results of operations for the full year or any other interim period. Certain prior period amounts have been reclassified to conform to the current period presentation.

During the year ended December 31, 2003, we sustained a significant loss in the first half of the year. Based on these results, management effected a restructuring plan designed to return the company to profitability by year’s end without sacrificing our significant engineering investments in a next generation of products. Previously, we had achieved operating and overall profitability as well as positive cash flows for the year ended December 31, 2002. We believe that our cash and cash equivalents and cash flows from operations will be sufficient to meet our operating, investing and financing cash flow requirements through at least the next 12 months. Our ability to maintain growth and profitability in 2004 and beyond is dependent on market acceptance of our existing and next generation of G2 and G2-based products and related services and on renewal of maintenance contracts for customer support at near-current levels.

Our financial statements have been prepared under the assumption that we will continue as a going concern. Based on current forecasts, management believes that we have sufficient liquidity to finance operations for the next twelve months. Management’s expectations for future revenue growth, profitability, and operating cash flows involve significant judgments and estimates. Should these judgments and estimates prove to be inaccurate, we have the intent and ability to reduce our costs and delay, scale back, or eliminate certain of our activities in order to ensure that we maintain positive cash and working capital. Any of these actions could have a material adverse long-term effect on our business, financial condition and results of operations.

6

Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

3. Comprehensive Income (Loss )

The components of comprehensive income (loss) for the three- and six-month periods ended June 30, 2004 and 2003 are as follows (in thousands):

4. Net Income (Loss) Per Share

The following is a reconciliation of basic and diluted weighted average shares used in the computation of net income (loss) per share (in thousands):

Options to purchase 232,709 shares of common stock with an exercise price between $2.03 and $10.00 per share were outstanding in the second quarter of 2004, and options to purchase 249,250 shares of common stock with an exercise price between $2.03 and $10.00 per share were outstanding in the six-month period ended June 30, 2004 but were excluded from the computation of diluted earnings per share because such options were anti-dilutive in the respective periods since their exercise prices exceeded the market value of our common stock . All options to purchase a total of 1,362,890 shares of common stock were outstanding for each of the three- and six- month periods ended June 30, 2003, but were excluded from the computation of diluted earnings per share because such options were anti-dilutive as we had net losses in those periods.

5. Stock Based Compensation

We follow the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of SFAS Statement No. 123.” We continue to recognize compensation costs using the intrinsic value based method described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.”

7

Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Net income (loss) and net income (loss) per share as reported in these consolidated financial statements on a pro forma basis, as if the fair value based method described in SFAS No. 123 had been adopted, are as follows:

6. Segment Reporting

Revenue is presented geographically based on the country to which the product is shipped or where the services are provided. The following table presents revenues by geographic area:

Revenues from one customer represented 27% and 14% of total revenues for the three- and six- months ended June 30, 2004.

The following table presents our long-lived assets, net of depreciation and amortization, as of June 30, 2004 and December 31, 2003 (in thousands):

8

Table of Contents

GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

7. Employee Stock Purchase Plan

Our 1995 Employee Stock Purchase Plan (the “Purchase Plan”) was adopted by our Board of Directors in November 1995 and approved by our stockholders in January 1996. The Purchase Plan authorized the sale of common stock to participating employees. As of December 31, 2003, the number of shares of common stock reserved for issuance under the Purchase Plan was 1,200,000.

All of our employees meeting certain eligibility requirements were able participate in the Purchase Plan. An employee could elect to have a whole number percentage from 1% to 10% of his or her base pay withheld during a payroll deduction period, known as an “Offering Period,” for purposes of purchasing shares under the Purchase Plan. The price at which shares could be purchased during each offering was 85% of the fair market value per share of our common stock on either the first day or the last day of the Offering Period, whichever was lower. Each of the Offering Periods was six months long. However, the Compensation Committee of the board of directors could, at its discretion, choose an offering period of 12 months or less for each of the offerings and choose a different Offering Period for each offering. Under the Purchase Plan, we sold 1,159,603 shares as of June 30, 2004, of which 54,036, 173,287, and 181,702 were issued in 2004, 2003, and 2002, respectively.

Effective June 15, 2004, our Board of Directors voted to discontinue the Purchase Plan.

8. Guarantor Arrangements

In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, while the disclosure requirements are applicable in 2002. We have adopted FIN No. 45, and the adoption of FIN No. 45 did not have a material impact on our financial position or results of operations

The following is a summary of the agreements that we have determined are within the scope of FIN No. 45:

As permitted under Delaware law, we have agreements whereby we will indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the officer or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a Director and Officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. All of these indemnification agreements were grandfathered under the provisions of FIN No. 45 as they were in effect prior to December 31, 2002. Accordingly, our liability for these agreements as of June 30, 2004 is not material.

We enter into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we believe our liabilities recorded for these agreements as of June 30, 2004 are immaterial.

9. Restructuring Charges

In June 2003, our board of directors approved a workforce reduction plan to reduce our expenses to a level commensurate with then current levels of revenue. In accordance with this plan, we recorded a restructuring charge of $250,000 in June 2003, which was later adjusted to $216,000 during the fourth quarter of 2003. The charge was based on estimates of the cost of the workforce reduction program, including special termination benefits, settlement and involuntary severance benefits related to postretirement benefit plans in Europe, and related legal costs. Substantially all of the restructuring charges were paid as of June 30, 2004.

9

Table of Contents

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

Forward-Looking Statements

This quarterly report contains forward-looking statements and information relating to us and our subsidiaries, which are based on management’s beliefs, as well as assumptions made by our management and information currently available to us. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. When used herein, words such as “anticipate”, “believe”, “estimate”, “expect”, “intend” and similar expressions, as they relate to our management or us, identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, and assumptions, including but not limited to those factors set forth below under the caption “Factors That May Affect Future Results”. Should one or more of these risks or uncertainties materialize, or should an underlying assumption prove incorrect, actual results may vary materially from those described in this report as anticipated, believed, estimated, expected or intended. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. We undertake no obligation to update or revise any forward-looking statements.

Business Overview

We were incorporated in Delaware in 1986 to develop and sell software products for expert operations management. Our flagship product has been, and continues to be, G2^®, which can emulate the reasoning of human experts as they assess, diagnose, and respond to unusual operating situations or as they seek to optimize operations. We have also developed a number of market-specific products using G2 as a platform. Since our inception, we have sold over 17,000 licenses to customers in a variety of industries.

Over the years we have developed and improved G2 and its related products on a regular basis, in terms of performance, functionality and ability to integrate with a wide variety of industry-standard products and protocols. We released a major version of G2, version 7.0, in March 2003, which constituted a significant advance in our product. Version 7.0 included many significant enhancements intended to bring G2 into line with current industry standards. Version 7.1 was released in December 2003, adding to G2’s integration capabilities with support for message-oriented middleware and other capabilities. In June 2004, we released G2 version 8.0, which represents a generational advance in our G2 product line, with major new capabilities for reasoning, integration, embeddability, user interfaces, and developer productivity.

In 2003, we refocused our direct sales force on generation of new business in three vertical markets: chemical, oil and gas; government, and water utilities. Our sales to these vertical markets involve a mix of direct sales to end users and indirect sales through partners. In geographic areas where we do not have direct sales force coverage, or in market sectors where we do not possess the requisite detailed industry knowledge to deploy our products successfully, we work with channel partners. These partners pursue new business based on Gensym products in various markets including business process management, various manufacturing sectors, telecommunications, and transportation.

To assist our end users and partners in developing applications, we offer professional services in the U.S., Europe, and the Middle East. In some cases we enter into fixed price contracts to deliver application solutions.

We conduct our business in North and South America, Europe, the Middle East, Africa and the Asia-Pacific region.

The following is the breakdown of revenue by product and service revenue (in thousands):

Prices for our products are generally denominated in U.S. dollars or Euros. The chemical, oil and gas industries are a major market for us. The U.S. Government, particularly the Department of Defense, is a major customer. We have several significant OEM partners, among them Siemens, Ericsson, and Motorola.

10

Table of Contents

Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. 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 those related to bad debts, income taxes, and contingencies. 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.

For a more detailed explanation of the judgments made in these areas, refer to our Annual Report on Form 10-K for the year ended December 31, 2003. Our critical accounting policies, as detailed in our Form 10-K for the year ended December 31, 2003, have not changed during the six-month period ended June 30, 2004.

Results of Operations

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

11

Table of Contents

Revenues

Three and Six months ended June 30, 2004 and 2003

Revenues

We derive revenue from two sources: product and services. Product revenues include revenues from sales of licenses for use of our software products. Services revenues consist of fees for support and maintenance, which is generally provided on an annual contract basis; consulting services; and training courses related to our products.

Total revenues for the three-month period ended June 30, 2004 were $4,399,000, an increase of $1,049,000, or 31%, from the same period in 2003. The increase was attributable to an increase of $1,071,000, or 112%, in license revenue offset by a decrease of $22,000, or 1%, in services revenue. Total revenues for the six-month period ended June 30, 2004 were $8,455,000, an increase of $1,647,000, or 24%, from the same period in 2003. The increase was attributable to an increase of $1,766,000, or 88%, in license revenue offset by a decrease of $119,000, or 3%, in services revenue.

International revenues represented 39% and 51% of our total revenues for the three-month periods ending June 30, 2004 and 2003, respectively. This decrease is primarily due to a large order received through a US government prime contractor and recognized in the second quarter of 2004 and a decrease in consulting revenues in Europe. International revenues represented 50% and 54% of our total revenues for the six-month periods ended June 30, 2004 and 2003, respectively. The reasons for the decrease in international revenues for the six-month period are the same as those pertaining to the quarter recently completed.

We currently have one customer that accounts for 27.3% and 14.2% of revenue for the three and six month period ended June 30, 2004, respectively.

Product. Product revenues for the three-month period ended June 30, 2004 were $2,029,000, an increase of $1,071,000, or 112%, from the same period in 2003. This increase was mainly attributable to a significant order from the US government. Product revenues for the six-month period ended June 30, 2004 were $3,768,000, an increase of $1,766,000, or 88% from the same period in 2003. The reasons for the increase in product revenues for the six-month period are the same as those pertaining to the quarter recently completed.

Services. Services revenues for the three-month period ended June 30, 2004 were $2,370,000, a decrease of $22,000, or 1%, from the same period in 2003. Services revenues for the six-month period ended June 30, 2004 were $4,687,000, a decrease of $119,000, or 3%, from the same period in 2003. This decrease was due to a decrease in customer support revenues of $338,000, or 9%, offset by an increase in consulting and educational services revenues of $219,000, or 23%.

Cost of Revenues

Cost of revenues primarily consists of consulting labor, technical support costs, general office expenses, and the costs of material and labor involved in producing and distributing our software. These costs for the three-month period ended June 30, 2004 were $1,254,000, an increase of $255,000, or 26%, from the same period in 2003. This increase was primarily due to additional costs associated with the significant order from the US government. Our gross margin percentage increased to 71% for the three-month period ended June 30, 2004 from 70% for the same period in 2003 as a result of higher product sales. Cost of revenues for the six-month period ended June 30, 2004 was $2,209,000, an increase of $276,000, or 14%, from the same period in 2003. The reasons for the increase are the same as those pertaining to the quarter recently completed. Our gross margin increased to 74% for the six-month period ended June 30, 2004 from 72% for the same period in 2003 primarily due to the increase in revenues for the period.

Product. Product cost of revenues for the three-month period ended June 30, 2004 was $338,000, an increase of $116,000, or 52%, from the same period in 2003. This increase was primarily due to additional costs associated with the significant order from the US government offset by a decrease in commissions and royalties. Product cost of revenues for the six-month period ended June 30, 2004 was $479,000, an increase of $30,000, or 7%, from the same period in 2003. This increase is due to the same reasons as those pertaining to the quarter recently completed.

Services. Services cost of revenues for the three-month period ended June 30, 2004 was $916,000, an increase of $139,000, or 18%, from the same period in 2003. The increase in service costs was primarily due to additional costs associated with the significant order from the US government. Services cost of revenues for the six-month period ended June 30, 2004 was $1,730,000, an increase of $246,000, or 17%, from the same period in 2003. The increase in service costs was primarily due to the same reasons as those pertaining to the quarter recently completed.

Operating Expenses

Sales and Marketing. Sales and marketing expenses consist primarily of costs associated with personnel involved in the sales and marketing process, sales commissions, sales facilities, travel and lodging, trade shows and seminars, advertising, and promotional materials. These expenses for the three-month period ended June 30, 2004 were $1,078,000, a decrease of $298,000, or 22%, from the same period in 2003. The decrease was primarily attributable to a decrease in sales personnel costs and their related travel costs resulting from the cost control program implemented in June of 2003. Sales and marketing expenses for the six-month period ended June 30, 2004 were $2,148,000, a decrease of $757,000, or 26%, from the same period in 2003. The decrease in sales and marketing costs was primarily due to the same reasons as those pertaining to the quarter recently completed. Sales and marketing expenses for the three-month period ended June 30, 2004 decreased to 24% of revenues from 41% for the same period in 2003. The decrease in percent of revenue was the result of an increase in product revenues and a decrease in expenses. Sales and marketing expenses for the six-month period ended June 30, 2004 decreased to 25% of revenues from 43% for the same period in 2004. The decrease in percent of revenues was caused by the same reasons as those pertaining to the quarter recently completed.

12

Table of Contents

Research and Development. Research and development expenses consist primarily of costs of personnel, equipment and facilities. These expenses for the three-month period ended June 30, 2004 were $889,000, an increase of $73,000, or 9%, from the same period in 2003. This increase is primarily attributable to additional personnel costs related to enhancing our product line. Research and development expenses for the six-month period ended June 30, 2004 were $1,746,000, an increase of $68,000, or 4%, from the same period in 2003. This increase in research and development expenses was caused by the same reasons as those pertaining to the quarter recently completed. Research and development expenses for the three-month period ended June 30, 2004 decreased to 20% of revenues from 24% for the same period in 2003. The decrease in percent of revenue was primarily the result of an increase of product revenues. Research and development expenses for the six-month period ended June 30, 2004 decreased to 21% of revenues from 25% for the same period in 2003. The decrease in percent of revenue was primarily the result of an increase of product revenues.

General and Administrative. General and administrative expenses consist primarily of personnel costs for finance, administration, operations and general management, as well as legal and accounting expenses. These expenses for the three-month period ended June 30, 2004 were $957,000, a decrease of $124,000, or 12%, from the same period in 2003. The decrease was mainly attributable to lower professional service costs. General and administrative expenses for the six-month period ended June 30, 2004 were $1,937,000, an increase of $141,000, or 8%, from the same period in 2003. The increase was mainly attributable to an increase in recruiting costs and personnel expense and the reduction of a bad debt reserve reduction taken in 2003. General and administrative expenses for the three-month period ended June 30, 2004 decreased to 22% of revenues from 32% for the same period in 2003. The decrease was mainly attributable to the increase in revenues. General and administrative expenses for the six-month period ended June 30, 2004 decreased to 23% of revenues from 26% for the same period in 2003. The decrease was mainly attributable to the increase in revenues.

Restructuring. In June 2003, our board of directors approved a workforce reduction plan to reduce our expenses to a level that was commensurate with then current levels of revenue. As a result of implementation of this plan, we recorded a pre-tax restructuring charge of $250,000 in June 2003, which was later adjusted to $216,000 during the fourth quarter of 2003. The charge is based on estimates of the cost of the workforce reduction program, including special termination benefits, settlement and involuntary severance benefits related to postretirement benefit plans in Europe and related legal costs. No costs were incurred prior to June 30, 2003, and the plan was completed by June 30, 2004. We paid $14,000 and $131,000 of restructuring expenses for the three- and six-month period ended June 30, 2004, respectively.

Other income, net. Other income (expense), net consists primarily of interest income and expense, realized gains or losses on foreign exchange transactions, and translation adjustments charged to income or expense. Other expense, net for the three-month period ended June 30, 2004 was $12,000, compared to other income, net of $86,000 for the same period in 2003. The current other expense is primarily due to foreign exchange rate losses due to the continued weakening of the US dollar. Other expense, net for the six-month period ended June 30, 2004 was $65,000, compared to other income of $109,000 for the same period in 2003. The current other expense is primarily due to foreign exchange rate losses due to the continued weakening of the US dollar.

Income Taxes. Our provision for income taxes primarily pertains to foreign withholding tax and income taxes in foreign jurisdictions where our wholly owned subsidiaries have taxable income but do not have operating loss carry forwards. Provision for income taxes for the three-month period ended June 30, 2004 was $19,000, compared to $102,000 for the same period in 2003. The decrease in the tax provision for the three months ended June 30, 2004 is due to losses in certain foreign jurisdictions where we had income for the three months ended June 30, 2003. Provision for income taxes for the six-month period ended June 30, 2004 was $44,000, compared to $179,000 for the same period in 2003. The decrease in the tax provision for the six months ended June 30, 2004 is due to losses in certain foreign jurisdictions where we had income for the six months ended June 30, 2003.

LIQUIDITY AND CAPITAL RESOURCES

Our June 30, 2004 cash and cash equivalents amounted to $3,626,000, an increase of $1,808,000 from $1,818,000 at December 31, 2003. Net cash provided by operating activities for the six-month period ended June 30, 2004 was $1,574,000. Specifically, we had a net income of $306,000, net of non-cash expenses of $310,000 (depreciation and amortization, loss on disposal of equipment, and non-cash compensation), $1,556,000 in cash received from accounts receivable and a $163,000 decrease in accounts payable offset by an increase of $153,000 in prepaid expenses and other assets, and decreases of $8,000 in accrued expenses and $600,000 in deferred revenue.

Cash provided by investing activities for the six-month period ended June 30, 2004 was $178,000, which consisted of a decrease of $187,000 in other assets primarily related to a release of restricted cash to cash offset by purchases of property and equipment of $9,000.

Cash provided by financing activities for the six-month period ended June 30, 2004 was $10,000, consisting of $63,000 in proceeds from exercise of stock options and issuance of common stock under stock plans offset by $53,000 in payments under capital leases.

We currently finance our operations, along with capital expenditures, primarily through cash flows from operations and our current cash. Our lease commitments consist of operating leases primarily for our facilities and computer equipment. We also have capital leases for certain computer equipment.

Our financial statements have been prepared under the assumption that we will continue as a going concern. Based on current forecasts, management believes that we have sufficient liquidity to finance operations for the next twelve months. Management’s expectations for future revenue growth, profitability, and operating cash flows involve significant judgments and estimates. Should these judgments and estimates prove to be inaccurate, we have the intent and ability to reduce our costs and delay, scale back, or eliminate certain of our activities in order to ensure that we maintain positive cash and working capital. Any of these actions could have a material adverse long-term effect on our business, financial condition and results of operations.

13

Table of Contents

Commitments and Contingencies

Leases

We lease our facilities and certain equipment under operating and capital leases. The future minimum annual payments under these leases at June 30, 2004 are as follows:

Litigation

On November 13, 2001, we, and our directors were served with a complaint filed by one of our stockholders, Special Situations Fund, III, L.P., in Delaware Chancery Court in and for New Castle County. In April 2004, we received notice that the plaintiff dismissed this action without prejudice as to all defendants.

Stock Repurchase Program

In the third quarter of 1998, we began a program to repurchase up to 650,000 shares of our common stock on the open market. As of June 30, 2004, 501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2004 or 2003. During the three months ended June 30, 2004 and 2003, respectively, we reissued 4,878 and 23,564 shares of common stock to non-employee directors and a consultant. During the six months ended June 30, 2004, and 2003, respectively, we reissued 9,678 and 37,512 shares of common stock to non-employee directors and a consultant. As of June 30, 2004, 375,491 shares remained in treasury at a cost of $1,401,000.

Related party transaction

On January 9, 2002 we entered into a three-year Original Equipment Manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation involving three employees who continue to work for us. The agreement calls for the payment of royalties, based on a fixed and determinable percentage of the product sales price, in connection with our use of their product. These payments are to be made within 30-days after payment from the end user is received. During the three- and six-month periods ended June 30, 2004, we paid Integration Objects a total of $50,000 and $71,000, respectively.

Factors That May Affect Future Results

The following important factors, among others, could cause our actual operating results to differ materially from those indicated or suggested by forward-looking statements made in this Form 10-Q or presented elsewhere by our management from time to time.

We have a history of operating losses, and we may not remain profitable.

We incurred operating losses for two out of the three years ended December 31, 2003, including fiscal year 2003. In August 2001, we announced a strategic restructuring of our company that included a 40% reduction in workforce, a realignment of our software and services product lines, and a renewed focus on our existing customers. With the restructuring, we achieved profitability for each fiscal quarter of 2002 and for the year ended December 31, 2002, although our revenues declined from the fiscal year ended December 31, 2001. In June of 2003, our Board of Directors approved a workforce reduction plan. We incurred operating losses in each of the first three quarters of 2003 and for the year ended December 31, 2003 but achieved net income profitability in the fourth quarter of 2003 and the first and second quarters of 2004. Our ability to achieve and maintain profitability is dependent on continued revenue from new and existing customers and expense control. There can be no assurance that we will return to profitability.

14

Table of Contents

We are reliant on fees from maintenance contracts and renewals. If we fail to retain our maintenance customers, our revenues may be adversely affected.

We rely on maintenance contract renewals for a significant percentage of our revenue, as software maintenance fees have become a large component of our total revenues, representing 44%, 39% and 37% of our total revenues in the years ended December 31, 2003, 2002 and 2001, respectively., Software maintenance fees represented 41% of our total revenues for each of the three- and six- months ended June 30, 2004. While a maintenance contract on our products is mandatory for the first year after purchase, subsequent renewals of the maintenance contract are at the discretion of our customers. Accordingly, our failure to retain maintenance customers or a significant decline in the rate of maintenance contract renewals could have a material adverse effect on our business, results of operations, cash flows, and financial position.

We rely heavily on indirect distribution channels and strategic partner relationships for the sales of our products. If these relationships are disrupted, our revenues may be adversely affected.

We sell our products in part through value-added resellers, systems integrators, original equipment manufacturers and distributors, which are not under our control. Sales of our products by such channel partners represented 56%, 52% and 55% of our product revenues in years ended December 31, 2003, 2002 and 2001, respectively. For the three- and six- months ended June 30, 2004, sales through such channel partners represented 31% and 56% of our product revenues, respectively. We rely heavily on our indirect sales partners for sales of our expert operations management products to new customers. The loss of major original equipment manufacturers or resellers of our products, a significant decline in their sales, or difficulty on the part of such third-party developers or resellers in developing successful G2-based applications could have a material adverse effect on our business, results of operations, cash flows or financial position. There can be no assurance that we will be able to attract or retain additional qualified third-party resellers, or that third-party resellers will be able to effectively sell and implement our products. In addition, we rely on third-party resellers to provide post-sales service and support to our customers, and any deficiencies in such service and support could adversely affect our business, results of operations, cash flows, or financial position.

We depend heavily on our sales and marketing force.

Our future success in the expert operations management marketplace will depend, in part, upon the productivity of our sales and marketing personnel and our ability to continue to attract, integrate, train, motivate and retain new sales and marketing personnel. There can be no assurance that our investment in sales and marketing will ultimately prove to be successful. In addition, there can be no assurance that our sales and marketing personnel will be able to compete successfully against the significantly more extensive and better funded sales and marketing operations of many of our current and potential competitors. Our inability to manage our sales and marketing personnel effectively could have a material adverse effect on our business, results of operations, cash flows, or financial position.

Our quarterly operating results may vary, leading to fluctuations in trading prices for our common stock and possible liquidity problems.

We have experienced, and may experience in the future, significant quarter-to-quarter fluctuations in our operating results. There can be no assurance that revenue growth or profitable operations can be attained on a quarterly or annual basis in the future. Our sales cycle typically ranges from 6 to 12 months, and the cost of acquiring our software, building and deploying applications, and training users represents a significant expenditure for customers. Our relatively long sales cycle and high license fees, together with fixed short-term expenses, can cause significant variations in operating results from quarter to quarter, based on a relatively small variation in the timing of major orders. Factors such as the timing of new product introductions and upgrades and the timing of significant orders could contribute to this quarterly variability. In addition, we ship software products within a short period after receipt of an order and typically do not have a material backlog of unfilled orders of software products. Therefore, revenues from software licenses in any quarter are substantially dependent on orders booked in that quarter. Historically, a majority of each quarter’s revenues from software licenses have come from license contracts that have been executed in the final weeks of that quarter. The revenues for a quarter may include some large orders. If the timing of any of these large orders is delayed, it could result in a substantial reduction in revenues for that quarter. Our expense levels are based in part on expectations of future revenue levels. A shortfall in expected revenues could therefore result in a disproportionate decrease in our results of operations and cash flows, which may impact our ability to continue as an independent concern.

15

Table of Contents

Sales of our products are highly dependent on our customers’ capital expenditure budgets. If an economic downturn causes our customers to reduce their capital expenditures, our revenues may be adversely affected.

Because capital expenditures are often viewed as discretionary by organizations, sales of our products for capital budget projects are subject to general economic conditions. Future recessionary conditions in the industries that use our products may adversely affect our business, results of operations, cash flows, or financial position.

We rely heavily on revenues from our G2 and G2-based products. If demand for the G2 product declines, our revenues may be adversely affected.

Substantially all of our license revenues are derived from G2, a customizable object-oriented development and deployment platform for building expert operations management systems, and from software application products based on G2 and other core technologies. Accordingly, our business and financial results are substantially dependent upon the continued customer acceptance and deployment of G2 and our other products. The timing of major G2 releases may affect the timing of purchases of our products. We have introduced several G2-based products for building applications and are developing others. We believe that market acceptance of these products will be important to our future growth. There can be no assurance that such products will achieve market acceptance or that new products will be successfully developed.

In addition, we rely on many of our distribution partners to develop G2-based products for specialized markets. Accordingly, our business and financial results are also linked to the continued successful product development by our partners and market acceptance of such G2-based products. Any decline in the demand for G2 and our other products, whether as a result of competitive products, price competition, the lack of success of our partners, technological change, the shift in customer demand toward complete solutions, or other factors, could have a material adverse effect on our business, results of operations, cash flows, or financial position.

Our business may be adversely affected if we fail to develop new products and respond to changes in technology if we develop new technology and it is not accepted by the market.

The market for our products is characterized by rapid technological change, evolving industry standards, changes in end-user requirements, and frequent new product introductions and enhancements. Our future success will depend in part upon our ability to enhance our existing products, to introduce new products and features to meet changing customer requirements and emerging industry standards, and to manage transitions from one product release to the next. We have, from time to time, experienced delays in introducing new products and product enhancements. There can be no assurance that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products and product enhancements. There also can be no assurance that we will successfully complete the development of new or enhanced products, that we will successfully manage the transition to future versions of G2, or to successor technology, or that our future products will achieve market acceptance. In addition, the introduction of products embodying new technologies and the emergence of new industry standards could render our existing products and products currently under development obsolete and unmarketable. From time to time, new products, capabilities, or technologies may be announced that have the potential to replace or shorten the life cycle of our existing product offerings. There can be no assurance that announcements of currently planned or other new product offerings will not cause customers to defer purchasing our existing products.

16

Table of Contents

Our business may suffer if we fail to address the challenges associated with international operations.

Our international revenues represented 39% and 51% of our total revenues for the three months ended June 30, 2004 and 2003, respectively. Our international revenues represented 50% and 54% of our total revenues for the six months ended June 30, 2004 and 2003, respectively. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. The international portion of our business is subject to a number of inherent risks, including difficulties in building and managing international operations, difficulties in localizing products and translating documentation into local languages, fluctuations in the value of international currencies including the Euro, fluctuating import/export duties and quotas, and unexpected regulatory, economic, or political changes in international markets. There can be no assurance that these factors will not adversely affect our business, results of operations, cash flows, or financial position.

Our business may suffer if we fail to remain competitive with other companies offering similar products and services.

A number of companies offer products that perform certain functions of G2 for specific applications. In all of our markets, there is competition from “point solutions,” real-time and expert system products, and internally developed software. There are commercially available software development tools that software application developers or potential customers could use to build software that has functionality similar to our products.

In addition, we believe that end users in our markets are increasingly seeking application-specific products and components as well as complete solutions, rather than general software tools to develop application-specific functionality and solutions. Meeting this demand has required us to modify our sales approach. We are increasingly reliant on indirect channel partners, including original equipment manufacturers, value-added resellers, and systems integrators, to satisfy market requirements. A number of software companies offer products that compete in specific application areas addressed by these partners, such as cement kiln control, manufacturing execution systems, logistics systems, and network management, and they could be successful in supplying alternatives to products based on our software.

Certain companies, such as Micromuse and Aspen Technology, sell “point solutions” that compete with our expert operations management products with respect to specific applications or uses. Several companies, including Ilog S.A., Pavilion, and System Management Arts, offer expert operations management products with limited real-time, expert system, or fault isolation capabilities, but at lower price points than those provided by us. Certain competitors in this category have greater financial and other resources than we do and might introduce new or improved products to compete with G2, possibly at lower prices.

Many of our customers have significant investments in their existing solutions and have the resources necessary to enhance existing products and to develop future products. These customers may develop and incorporate competing technologies into their systems or may outsource responsibility for such systems to others who do not use our products. There is no assurance that we can successfully persuade development personnel within these customers’ organizations to use G2-based products that can cost effectively compete with their internally developed products. Thus there could be a reduction in the need for our products and services that may limit our future opportunities.

17

Table of Contents

We believe that continued investment in research and development and sales and marketing will be required to maintain our competitive position. There can be no assurance that competitors will not develop products or provide services that are superior to our products or services or achieve greater market acceptance. Competitive pressures faced by us could force us to reduce our prices, which could result in reduced profitability. There can be no assurance that we will be able to compete successfully against current and future sources of competition or that such competition will not have a material adverse effect on our business, results of operations, cash flows, or financial position.

Our software is complex and may contain undetected errors. Such errors could cause costly delays in product introduction or require costly software design modifications.

Complex software products such as those that we offer may contain unintended errors or failures commonly referred to as “bugs.” There can be no assurance that, despite significant testing by us and by current and potential customers, errors will not be found in new products after commencement of commercial shipments. Although we have not experienced material adverse effects resulting from any such errors or defects to date, there can be no assurance that errors or defects will not be discovered in the future that could cause delays in product introduction and shipments or require design modifications that could adversely affect our business, results of operations, cash flows, or financial position.

Because we rely heavily upon proprietary technology, our business could be adversely affected if we are unable to protect our proprietary technology or if third parties successfully assert infringement claims against us.

Our success is heavily dependent upon our proprietary technology. We rely upon a combination of trade secret, contract, copyright, patent, and trademark law to protect our proprietary rights in our products and technology. We enter into confidentiality and/or license agreements with our employees, third-party resellers, and end users and limit access to and distribution of our software, documentation, and other proprietary information. In addition, we have placed technical inhibitors in our software that prevent such software from running on unauthorized computers. However, effective patent, copyright, and trade secret protection may not be available in every country in which our products are distributed. There can be no assurance that the steps taken by us to protect our proprietary technology will be adequate to prevent misappropriation of our technology by third parties, or that third parties will not be able to develop similar technology independently. In addition, there can be no assurance that third parties will not assert infringement claims in the future or that such claims will not be successful.

In August 2001, we received a letter from a third party alleging that we are infringing one or more of their patents relating to neural networks and expert systems and the control of processes. At this time, no formal legal action has been filed. While we believe that these allegations are without merit, there can be no assurance that the third party will not file formal legal action relating to its claims or, if formal legal action is filed, that our defense against those claims will be successful.

Our research and development in new reasoning technologies may not lead to profitable commercialization.

We are developing a new software reasoning platform, TrueManage, that is designed for handheld computing devices and targeted at application markets not currently addressed by our G2 and G2-based products. We have also begun to develop a TrueManage application product called LifeVisor, a cell phone device for self-management of chronic conditions such as diabetes and obesity. Development of TrueManage and LifeVisor is complex, requiring specialized technical expertise. The targeted handheld computing markets are experiencing rapid advancements in related technologies and applications. We anticipate that it will require significant funding to develop, launch, and build distribution channels for TrueManage and LifeVisor. Our strategy is to distribute these products through other companies that have significantly larger presence and scale in the targeted markets than we do. There can be no assurance that we will be able to successfully complete the development of TrueManage and LifeVisor, that we will be able to provide functionality that is accepted by the targeted markets, or that we will be able to build partnerships for profitable distribution of these products.

18

Table of Contents

Our stockholders may face an illiquid market for the shares of our stock that they own.

On August 21, 2001, our stock was delisted from the NASDAQ National Market because we failed to meet the applicable listing standards. Our common stock currently trades on the OTC Bulletin Board. The delisting may negatively impact the liquidity of our common stock, not only in the number of shares that can be bought or sold, but also through delays in the timing of transactions and the reductions in potential security analyst and media coverage. This may reduce the demand for our common stock and its trading price. The delisting may also impair our ability to raise additional working capital.

ITEM 3. Qualitative and Quantitative Disclosures About Market Risk

Investment Portfolio

We do not use derivative financial instruments in our investment portfolio. If we place our funds in other than demand deposit accounts we use instruments that meet high credit quality standards, such as money market funds, government securities, and commercial paper. We limit the amount of credit exposure to any one issuer. At June 30, 2004, substantially all of our funds were in demand deposit accounts.

Impact of Foreign Currency Rate Changes

Our contracts with customers are generally denominated in U.S. dollars or Euros. We transact business in various countries and thus have exposure to adverse movements in foreign currency exchange rates. This exposure is primarily related to intercompany receivable and payable balances that are recorded on the balance sheet in currencies other than the functional currency. These amounts are translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the statement of operations. In addition, we have certain cash balances held in currencies other than our functional currency or the functional currency of our subsidiaries. These amounts are translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the appropriate statements of operations.

ITEM 4. Controls and Procedures.

Our management, with the participation of our chief executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of June 30, 2004. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and our management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of June 30, 2004, as a result of the material weaknesses in our internal controls over financial reporting described below, our disclosure controls and procedures were not effective to ensure that information we are required to disclose in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

During, and shortly following, the fiscal quarter ended June 30, 2003, we experienced turnover in our accounting and finance organization. In particular, our corporate controller left our company, and our European controller was on a personal leave of absence beginning in June 2003, returned to full-time status in October 2003, and was on personal leave again from April 2004 through the present. Furthermore, our former chief financial officer left our company in early August 2003. Management determined that the loss, or temporary absence of, these personnel resulted in certain conditions which, when considered collectively, constitute a material weakness in our internal controls. Such conditions included:

19

Table of Contents

In addition to these weaknesses, our former independent auditors, PricewaterhouseCoopers LLP, identified certain other matters representing material weaknesses in internal controls over financial reporting in connection with their audit of our financial statements for the year ended December 31, 2003. These items included:

Beginning in the quarter ended September 30, 2003 we took a number of corrective actions to address the material weaknesses discussed above, including:

In addition, we implemented changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended June 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. These changes include:

We are currently evaluating our intercompany borrowing arrangements and intend to establish policies and procedures to evidence the accounting for intercompany borrowings and foreign currency translation adjustments. We are also in the process of establishing remote access for all of our bank accounts and adding our chief financial officer and chief executive officer as signatories to all of our bank accounts.

We have performed additional procedures to evaluate the extent to which the internal control weaknesses discussed above could have led to material misstatements in our consolidated financial statements. Based on our evaluation, we do not believe that the control weaknesses and deficiencies noted above led to any material misstatements in the consolidated financial statements included in this report.

20

Table of Contents

PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings

On November 13, 2001, we and our directors were served with a complaint filed by one of our stockholders, Special Situations Fund, III, L.P., in Delaware Chancery Court in and for New Castle County. The lawsuit asserted claims for, among other things, alleged breach of fiduciary duty and waste of corporate assets in connection with our rejection of a merger proposal by Rocket Software, the adoption of our proposed rights offering, and the execution of a letter of intent with Rocket Software relating to the sale of our NetCure product line. The complaint sought injunctive relief with respect to the Rocket Software merger proposal, the proposed rights offering and the sale of the NetCure product line to Rocket Software. On November 16, 2001, we and our directors were served with an amended and supplemental complaint further asserting that our directors breached fiduciary duties by consummating the sale of the NetCure product line to Rocket Software and allegedly refusing to negotiate with Rocket Software in connection with its merger proposal. The amended complaint also added Rocket Software as a defendant and asserted a claim against Rocket Software for aiding and abetting the alleged breaches of fiduciary duties. The amended complaint sought injunctive relief with respect to the Rocket Software merger proposal, rescission of the NetCure sale, and compensatory and/or recissionary monetary damages. On November 26, 2001, the court conducted a telephonic hearing on the plaintiff’s motion for expedited proceedings, and denied the motion at the conclusion of that hearing. On November 27, 2001, we were advised by plaintiffs’ counsel that, in light of the court’s decision on the motion to expedite proceedings, the plaintiffs intended to file a further amended complaint. In April 2004, we received notice that the plaintiff dismissed this action without prejudice as to all defendants.

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

The following table provides information about purchases by the company during the quarter ended June 30, 2004 of equity securities that are registered by the company pursuant to Section 12 of the Exchange Act:

GENSYM PURCHASES OF EQUITY SECURITIES¹

(1) We repurchased an aggregate of 501,300 shares of our common stock pursuant to the repurchase program that we publicly announced on July 1, 1998 (the “Program”).

(2) Our board of directors approved the repurchase by us of up to an aggregate of 650,000 shares of our common stock pursuant to the Program. Unless terminated earlier by resolution of our board of directors, the Program will expire when we have repurchased all shares authorized for repurchase thereunder.

(3) We do not anticipate making further purchases under this Program.

Item 5. Submission of Matters to a Vote of Security Holders

Our 2004 annual meeting of stockholders was held on May 27, 2004.

At our 2004 annual meeting of stockholders, our stockholders elected Frank Cianciotta and Lowell B. Hawkinson to serve as directors of the Company until our 2007 annual meeting of stockholders and until their successors are duly elected and qualified. In addition to the directors listed above who were elected at the 2004 annual meeting of stockholders, the terms of the following directors continued after the 2004 annual meeting: Robert A. Degan, Barry R. Gorsun, John A. Shane and Thomas E. Swithenbank.

The matters acted upon at the 2004 annual meeting of stockholders, and the voting tabulation for each such matter, are as follows:

Proposal 1: To elect two Class II directors to the board of directors for the ensuing three years:

Each of the above named individuals was elected as a Class II director.

21

Table of Contents

Proposal 2: To amend our 2000 Stock Incentive Plan to increase the number of shares of common stock authorized for issuance from 800,000 to 1,050,000:

The proposal was approved.

ITEM 6. Exhibits and Reports on Form 8-K

(a) Exhibits. The following exhibits are filed as part of this Report on Form 10-Q:

(b) The following Current Reports on Form 8-K were filed or furnished by us during the quarter ended June 30, 2004:

22

Table of Contents

SIGNATURES

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

23

Table of Contents

EXHIBIT INDEX

24